Chapter 1

The Nature of Accounting

and Its Business Environment
THE NATURE OF ACCOUNTING AND ITS BUSINESS ENVIRONMENT
LESSON 1-1 THE NATURE OF BUSINESS

Lesson Objectives
• define accounting
• describe its nature and functions in business

WHAT IS ACCOUNTING?
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.

The American Institute of Certified Public Accountants (AICPA) defines accounting as an 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 results thereof.

The Philippine Institute of Certified Public Accountants (PICPA) defines accounting 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
The nature of accounting is in its definition as follows:

1. 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.

2. 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.

3. Accounting is a service activity.

Service is the occupation or function of service. 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.

Note: Definitions of the terms above were taken from Merriam-Webster Dictionary
Four Aspects of Accounting
1. Recording – writing down of business transactions chronologically in the books of account as they
transpire.
2. Classifying – sorting similar and related business transactions into the three categories of assets,
liabilities, and owner’s equity.
3. 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.
4. 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.

The Basic Function of Accounting in Business

The aspects of accounting can be summed up to one basic function which is the generation of
relevant and timely financial information for interested parties. The data provided by accountants can
assist investors, government agencies, creditors, and management in making sound decisions. The
financial information provided about the activities of an economic organization makes it easily
comprehensible for users to assess its financial position as of a given time and results of operations for a
given period. This qualitative and quantitative financial data used by users relating to specific business
decisions makes accounting the language of business.

Test Your Understanding

1. What is accounting?

2. What are the four aspects of accounting?

3. What is the basic function of accounting in business?

LESSON 1-2 HISTORY OF ACCOUNTING

• know the origin and history of accounting

A BRIEF 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.html>.

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, archaeologists Dr. Gunter Dreyer of 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 believed to date back to 3,000 BCE or around 5,300 years ago.
These old stone labels were complete with marks representing accounts of oil and linens which were
believed to be paid to the king as taxes.

https://www.ee.ryerson.ca/~elf/abacus/intro.html https://www.metmuseum.org/toah/hd/papy/hd_papy.htm
https://en.wikipedia.org/wiki/Cuneiform https://en.wikipedia.org/wiki/Den_(pharaoh)
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 600 BCE,
they introduced money in 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’ books of account. It was the same in Rome where accounting helped establish their finance and
legal system. In fact, the Romans introduced 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 all properties in the name of the king upon
his invasion. In 1086, the Domesday Book contained of 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.
https://www.messagetoeagle.com/the-domesday-book-of-william-i-the-conqueror-detailed-register-of-who-owned-what-in-
england/http://livingthehistoryelizabethchadwick.blogspot.com/2010/08/medieval-monday-king-johns-accounts.html

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
Arithmetic, Geometry and Proportion). One section of this book De Computis et Scripturis (Of Recknonigs
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.

https://en.wikipedia.org/wiki/Luca_Pacioli

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 accountants (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 first national US accounting society. The American Association of Public
Accountants which provided a formal certification process for accountants was the predecessor of the
present American Institute of Certified Public Accountants (AICPA).

20th Century – The Evolution of Modern Accounting Standards

The American Institute 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 principles (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, Digital Age, or New Media Age, has
brought about a significant change in the work load 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 Reporting 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.

Test Your Understanding

Identify the term that best suits each statement.

__________1. The equivalent of present-day accountants during the Mesopotamian times.
__________2. Granted a royal charter to the Institute of Accountants in Glasgow on July 6, 1854, thereby
creating the profession of chartered accountant (CA), making accounting a formal profession.
__________3. This book contained all the real estate surveyed by William the Conqueror and the taxes
due to them.
__________4. This was signed into federal law on July 21, 2010 in response to the Great Recession. It
contains sixteen major areas of reform.
__________5. A calculating instrument developed by the ancient Sumerians in 5,000 BCE using row
beads.
__________6. This is where periodic reports vouched by certified public accountants were filed by all
publicly-traded companies who had to register before selling their securities to the public.
__________7. The archaeologist who unearthed clay tablets considered to be among the oldest written
tax accounting records.
__________8. The era that replaced hand tools with machine or power tools, otherwise known as the
factory system, and transformed accounting into an actual profession.
__________9. Considered to be the greatest corporate fraud case recorded in American history which
caused Arthur Andersen, one of the top audit firms in the United States to close business.
__________10. Developed in 4,000 BCE, this not only allowed recording of commercial transactions but
also the transcription of religious text, music, literature, and more.
__________11. He took possession of all properties in the name of the king upon his invasion.
__________12. He is considered the Father of Accounting.
__________13. Old stone labels, believed to date back to 3,300 BCE or around 5,300 years ago were
discovered in the tomb of this Egyptian King.
__________14. Established in 1973, this was tasked to set the accounting and auditing standards for
reports to be filed with the SEC which was previously done by AICPA.
__________15. He is the writer of Della Mercatura et del Mercante Perfetto (Of Trading and The Perfect
Trader) where the original idea of the double-entry bookkeeping was introduced.
__________16. Formed in the United States, this is the first national professional association for Certified
Public Accountants (CPA).
__________17. This was passed by the U.S. Congress in 2002 which imposed tougher restrictions on
accountants conducting consultancy services to their clients.
__________18. To date, this is considered to be the most ancient surviving accounting record in the
English language which contains the yearly accounting of rents, fines, and taxes due to the king of England
from 1130 to 1830.
__________19. This is the Greek city where the use of an annual budget which coordinated estimated ‘s
revenues and taxes paid by the citizens in relation to the nation’s expenditures was introduced.
__________20. Also known as the Computer Age, Digital Age, or New Media Age where manual, tedious
and time consuming tasks were replaced by faster and more accurate computer methods.
__________21. They introduced the use of coins in around 600 BCE which contributed to the
development of accounting.

LESSON 1-3 THE BUSINESS ENVIRONMENT

• Differentiate the branches of accounting

• Explain the types of services rendered in each branch of accounting
• Know the different types of business organizations
• Know the legal requirements in the formation of a business
• Classify the different types of business operations

THE DIFFERENT BRANCHES OF ACCOUNTING

1. Financial Accounting
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 principles (GAAP).
The financial information provided by financial accounting is used for decision making by both
internal and external users. Internal users include creditors, potential investors, employees, and
government agencies.

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
Section 109 of Presidential Decree (PD) No. 1445 states that government accounting encompasses
the process of analyzing, classifying, summarizing, and communicating all transactions involving the
receipt and disposition of government funds and property, and interpreting the results thereof. The
agencies responsible in performing government accounting functions are the Commission on Audit, the
Department of Budget and Management (DBM), and the Bureau of Treasury (BTr).

4. Auditing
Auditing is the examination and revies of accounting reports in order to ascertain their fairness,
propriety, and reliability. The independent auditor’s opinion provides reasonable assurance that the
financial statements under examination fairly present the company’s financial position and results of
operation in accordance with the generally accepted accounting principles (GAAP).

5. Tax Accounting
Tax services provided by accountants include the preparation of monthly value added tax,
percentage tax, expanded withholding tax returns, quarterly and annual tax returns, and any other taxes
applicable to business. Accountants work closely with clients in order to avoid tax problems with the
Bureau of Internal Revenue (BIR) and other local agencies through proper tax compliance while advising
clients about ways and measures to minimize taxes.

6. Cost Accounting
Cost accounting includes the collection, determination, allocation, assessment, interpretation,
and control of cost data, particularly the cost of production in a manufacturing concern. The cost of
production includes the raw materials, direct labor, factory overhead, and all other costs involved incident
in each stage of production of the finished goods.

7. Accounting Education
Accounting education involves planned grading and formal teaching in an educational institution.
The professional accountant imparts knowledge to students enrolled in an accounting subject either in
basic accounting or in higher accounting subjects. Accountants in the academe usually take post graduate
studies to achieve the required tenure.

8. Accounting Research
Accounting research involves conducting a careful and diligent study aimed at discovering and
interpreting facts, revising accepted theories in the light of new facts, or the practical application of such
new or revised theories for the generation of a new knowledge. It includes collecting information about
a particular subject in order to decide and implement new standards in accounting, presenting current
events that might affect the profession, or discovering new theories that will have an impact on existing
accounting knowledge.
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. Employees
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 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 of 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 operations, 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 Organizations

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

Advantages
a. There are minima 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.
Disadvantages
a. Resources are limited as the capital is provided only by the owner.
b. The liability of the owner is unlimited as he or she is accountable to all creditors of the business.
c. Infusion of knowledge in the management of the business is limited to one person only, which is
the 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 a profit.

Advantages
a. There are minimal costs and 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 actions 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 corporations 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 persons,
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 the 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.

Legal Requirements in the Formation of a Business

The sole proprietorship is the easiest business to register. It is registered with the Department of
Trade and Industry (DTI) under its Bureau of Trade Regulation and Consumer Protection.
For a partnership, the business is registered with the Securities and Exchange Commission (SEC)
upon submission of the following documents:
a. Proposed Articles of Partnership
b. Name Verification Slip
c. Bank Certificate Deposit
d. Alien Certificate of Registration, Special Investors Resident Visa, or proof of other types of visa (in
case of foreigners)
e. Proof of Inward Remittance (in case of non-resident aliens)

For a corporation, the following are the incorporation documents required to be filed with the
Securities and Exchange Commission (SEC):
a. Articles of Incorporation
b. By-laws
c. Treasurer’s Affidavit which should state compliance with the authorized subscribed and paid-up
capital stock requirements.
d. Bank Certificate which should state that the paid-up capital portion of the authorized capital stock
has been deposited to the issuing bank.
What should be stated upon registration of a corporation?
a. The name of the corporation which must not be identical, or deceptively or confusingly similar to
any existing corporation.
b. The purpose of the corporation.
c. Principal office of the corporation.
d. The term of life of the corporation which should not exceed fifty (50) years. This corporate
lifetime may, however, be extended for another fifty (50) years but the extension must not be
effected earlier than five (5) years before the expiration of its term.

For a cooperative, the business is registered with the Cooperative Development Authority (CDA)
upon submission of the following documents:
a. Economic Survey
b. Notarized Articles of Cooperation and By-Laws
c. Bonds of accountable officer or officers
d. Notarized sworn statement of the treasurer certifying that the required subscription and payment
of the authorized share capital and paid-up capital have been fulfilled.

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 its 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 services 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.
Examples: 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.

Examples: 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 purchased. 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.

Examples: shoe factory, food processing

1. What are the different branches of accounting? Describe the scope of each brand.
2. What are the different forms of business organizations? Give the advantages and disadvantages
of each business organization.
3. Who are the users of information? Give examples of each user.
4. What are the types of business according to business activity or operation? Give examples of each
type.

DRILL 1
Determine the type of business organization formed in each case. Then, determine the type of activities
or operations performed by the business.

1. Jack Ty and Jill Alunan were classmates since elementary. They went to college together and
recently passed the board exam for certified public accountants. They decided to form T. Alunan
Auditing Services.
2. Bill Lee, a marketing student, is looking for a business to help him fund his studies. He decides to
rent a stall near the university and hire a sales lady to help him sell the school supplies he buys
from Divisoria. Mark-up is usually 25% of the cost.
3. Juan Cruz and Pedro Co are both engaged in the production of soaps and shampoos. They decided
to join their businesses together in order to expand their market.
4. Alibaba, Seus, and three more friends, who are mechanical engineers, decide to open a plant
where they can produce machines to be sold to big factories in order to cut labor cost. Because
the cost of starting the business is substantial, they decide to invite incorporators to generate
more funds.

LESSON 1-4 ACCOUNTING CONCEPTS AND PRINCIPLES

• Define generally accepted accounting principles (GAAP)

▪ Know and appreciate the basic accounting principles used in the practice of
accounting

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

• These are broad, general statements or “rules” and “procedures” that serve as guides in the
practice of accounting.
• These are standards, assumptions, and concepts with general acceptability.
• These are measurement techniques and standards used in the presentation and preparation of
financial statements.
➢ 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 its fiscal year on April 30, 2017.
Note: A natural business year is any twelve-month period that ends when business activities are
at their lowest point.

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 material facts that will significantly affect the financial
statements must be indicated.
Example: Land bought at two million pesos in 2001 should be recorded at historical cost in the
2016 financial statements. However, the current market value of three million pesos in the year
2016 may be indicated in the financial statements for the year 2016 in the form of a footnote or
parenthetical note.

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 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.

What are generally accepted accounting principles?

DRILL 1
Identify the concept or principle that each statement refers to.

__________1. 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.
__________2. 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.

__________3. Approaches used in reporting must be uniformly employed from period to period to allow
comparison of results between time periods.

__________4. This states that all material facts that will significantly affect the financial statements must
be indicated.

__________5. All properties and services acquired by the business must be recorded at their original
acquisition cost.

__________6. The business enterprise is separate and distinct from its owners and from other business
enterprises.

__________7. All business transactions that will be entered in the accounting records must be duly
supported by verifiable evidence.

__________8. Income should be recognized at the rime it is earned such as when goods are delivered or
when services have been rendered.

___________9. Accounting information about the economic activities of an enterprise is provided for
specified time periods.

___________10. This refers to the assumption that the business enterprise will continue to operate
indefinitely.