CHAPTER I

PURPOSE AND NATURE OF ACCOUNTING

Learning Outcomes

At the end of the chapter, learners shall be able to:

 define accounting and describe its nature, branches and fields;

 explain the functions of accounting in business;
 identify and distinguish the different branches and fields of accounting;
 identify the users of financial information; and
 explain the basic accounting concepts and principles

Business and Accounting

Business is an undertaking where one seeks to make profit by selling

goods or rendering services. Some enterprises, however, are organized as non-
profit organizations to provide certain benefits to society. In any type of business
or organization, a lot of transactions and events happen every day. These
transactions should be recorded to have a ready reference for future operations.

Keeping records is an important aspect of a business. Without an

effective recording or accounting system and procedures, one would find it
difficult to determine how the business is fairing, whether it is earning profits or
incurring losses.

Through accounting, quantitative information can be identified, measured

and summarized into financial reports that are to be communicated to the
interested parties. These financial reports provide information about the financial
condition and results of business operations which are bases for decision-
making.

Types of Business Based on the Nature of Operations

A business organization can be classified based on the nature of business

operation. The purpose for which the business has been established will
determine the nature of activities. The following are the classifications:

1. Service business is one which is engaged in the rendering of

services to others for a fee. Examples are law firms, accounting firms,
auditing firms, medical clinics, barber shops, beauty parlors, stock
brokerage firms, recruitment agencies, and the like.

2. Trading business is engaged in the buying and selling of goods or

commodities produced by other businesses which are called
merchandise, hence, it is also called a merchandising business. It is
a link in the physical distribution chain acting as a wholesaler or a
 retailer firm. Examples are car dealers, grocery stores, supermarkets,
cell phone and accessory traders and gift shops.

3. Manufacturing business is engaged in the buying of raw materials,

converting them into finished products and selling to traders or final
consumers. Examples are car manufacturers, food processors, soft
drink bottling companies, drug manufacturers and paper mills.

The main difference between a trading and a manufacturing

business is that, a trading business buys goods and sells these goods
in the same form while a manufacturing business buys raw materials
and sells goods that were produced or processed out of the raw
materials.

4. Hybrid business is one which is involved in more than one type of

business activities (service, merchandising and manufacturing).

Forms of Business Organization

A business operates in a complex environment that affects decision-

making. Two of the most important factors making up the firm’s operating
environment are the legal form of business organization and taxes. The
accounting procedures depend on which form the organization takes. The three
forms of business organizations are:

1. Single or Sole Proprietorship. This business organization is owned

by an individual who has complete control over business decisions.
The owner is called proprietor, who generally is also the manager.
The owner is entitled to all the profits, but absorbs all losses. He owns
all the firm’s assets and is responsible for all the debts of the business.

From a legal point of view, the proprietor is not separable from the
business and is personally liable for all debts of the business.
However, from an accounting perspective, the business has a
separate and distinct personality from that of the owner.

The owner is not paid salaries nor wages from the business.
Instead, he can withdraw funds or properties from the firm.

2. Partnership. This is a business owned and operated by two (2) or

more persons known as partners, who bind themselves to contribute
money, property or industry to a common fund, with the intention of
dividing the profits between or among themselves.

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 The Articles of Co-Partnership which is to be filed at the Securities
and Exchange Commission (SEC) is a written agreement between or
among the partners, governing the formation, operation and
dissolution of the partnership.

3. Corporation. As defined in the Revised Corporation Code of the

Philippines (RA 11232), it is “an artificial being created by operation of
law, having the rights of succession and the powers, attributes and
properties expressly authorized by law or incident to its existence.”
The incorporation process is initiated by the filing of the Articles of
Incorporation with the SEC.

The owners are called shareholders or stockholders. These

owners are not directly involved in the management of the firm,
instead, they select managers designated as the Board of Directors to
run the firm for them.

Micro, Small and Medium Enterprises (MSMEs)

In 2008, the Magna Carta for Micro, Small and Medium Enterprises,
otherwise known as Republic Act 9501, was signed into law. This law seeks to
address problems faced by MSMEs particularly the lack of capital and access to
credit. It also updated the definition of MSMEs as follows:

Assets before financing No. of Employees

Micro Enterprise P3 Million and below 9 and below
Small Enterprise More than P3 Million to P15 Million 10 to 99
Medium Enterprise More than P15 Million to P100 Million 100 to 199

These MSMEs are registered as any of the legal forms and nature of
business. Enterprises with assets and employees above the MSME threshold
are considered large enterprises.

Definition of Accounting

The following definitions have been given by different authoritative bodies

in accounting:

Accounting is the process of identifying, measuring and communicating

economic information to permit informed judgements by users of the information
(American Accounting Association).

Accounting is 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 (Accounting Standards Council).

Accounting is the art of recording, classifying and summarizing in a

significant manner and in terms of money, transactions and events which are, in

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part at least, of a financial character and interpreting the results, thereof
(American Institute of Certified Public Accountants).

From the definitions given, accounting is a service activity that tries to

communicate financial information to interested users.

Important Activities in the Accounting Process

From the definitions, the three important activities in the accounting

process are:

1. Identifying is the recognition or non-recognition of business activities

as accountable events. Events are accountable when they affect the
assets, liabilities and equity of the business. There are business
activities and events which are not accountable because they cannot
be quantified, or expressed in terms of a unit of measure, like hiring of
employees and entering into a contract.

2. Measuring is the assigning of peso amounts to the accountable

economic transactions and events.

3. Communicating is the process of preparing and distributing

accounting reports to users of accounting information.

Phases of Accounting

Accounting covers four functions, namely:

1. Recording is the writing down on the books of accounts, the

business transactions or events. The technical term for this function is
bookkeeping. Bookkeeping is a systematic and chronological
recording of business transactions and events. It is systematic
because the Generally Accepted Accounting Principles (GAAPs) are
applied in the recording of transactions.

2. Classifying is the sorting or grouping of similar and interrelated

transactions into their respective classes. For example, in recording
the purchase of different goods which are intended for resale, the
account “Purchases” should be used for all purchases regardless of
the type of goods purchased. This is accomplished by posting to the
ledger. The ledger is a group of accounts which are categorized into
asset, liability, equity, revenue and expense accounts.

3. Summarizing is achieved through the preparation of financial

statements or financial reports. The financial statements summarize
the effects of all business transactions that occurred during a certain
period on the assets, liabilities and equities of the business.

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 4. Interpreting is being done after the transactions are summarized in
the financial statements in order to analyze or evaluate the liquidity,
solvency, stability and profitability of the business organization.

Liquidity is the ability of the business to pay for its current

obligations when they fall due. This is determined by comparing the
current assets against current liabilities of the business.

Solvency is the ability of the business to operate continuously and

smoothly. This is possible only if the assets of the business are
sufficient to meet the long-term obligations on the maturity dates and
that the owner’s capital is increasing due to profits earned by the
business.

Profitability is a situation in which an entity is generating a profit.

Profitability arises when the aggregate amount of revenue is greater
than the aggregate amount of expenses in a reporting period.

Accounting as the Language of Business

Accounting is considered as the language of business, as it is the medium

of communication between the business and the parties interested with the
financial activities of the business. Through accounting, business transactions
are identified, measured and summarized into accounting reports like financial
statements. These financial statements provide information about the financial
condition and results of operations of the business, which owners, creditors,
employees, and government agencies may use to make informed business
decisions.

Accounting and Bookkeeping

Whatever the type of business activity, all enterprises need common basic
information about financial operations. The function of providing information and
establishing financial records for planning and management of business affairs is
what accounting and bookkeeping is all about.

Bookkeeping is a procedural element of accounting. It is the process of

recording financial transactions and keeping financial records. It is the
information processing function of accounting where business data are collected
and summarized into financial reports. Accounting, on the other hand, includes
many complex activities such as bookkeeping, the design of an information
system that meets the user’s needs, the analysis and interpretation of financial
statements, preparation of tax and financial reports, budgeting, auditing,
planning and forecasting.

Accounting cannot exist independently of bookkeeping. An accountant

must know the principles and mechanics of bookkeeping. Hence, those who
study accounting are taught first the fundamentals of bookkeeping.

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 Today, computers are used for routine bookkeeping operations that used
to take weeks or months to complete manually. Basic accounting knowledge
however, is needed even though computers can do the routine tasks.

Fields of Accounting

The professional accountant may pursue a career in any of the following

areas of accounting practice: (1) Public Accounting, (2) Commerce and Industry,
(3) Government Accounting, and (4) Accounting Education.

The field of public accounting is where the professional accountant offers

to the public for a fee accounting services such as general accounting, auditing,
design and installation of accounting system, management advisory services, tax
planning services, and others.

The professional accountant in commerce and industry is employed in

any position requiring knowledge and skills in accounting where adherence to
GAAP and procedures are to be observed. This includes job titles as chief
accountant, internal auditor, budget officer, cost accountant, controller or finance
vice president.

The professional accountant in government may be employed in areas

where it requires the application of knowledge and skills of accounting in
accordance with prescribed standards. This includes employment at the
Commission on Audit (COA), National Treasury, Bureau of Internal Revenue,
Bureau of Customs, Department of Budget and Management, Department of
Finance, Bangko Sentral ng Pilipinas, or other governmental units or government
owned or controlled corporations (GOCCs).

The professional accountant in the field of education is one who helps

keep the accounting profession alive, relevant and interesting, undertakes
research works in an effort to bridge the gap between theory and practice, seeks
the rationale for changes in the profession and communicates current thinking to
those within the profession or who are about to enter the profession.

Other fields which the professional accountants would venture into include
entrepreneurship, personnel administration, insurance and marketing. They
become successful in these areas since they are versatile and have been trained
to meet the many problems that confront businesses.

Specialized Accounting Services

Financial Accounting is focused on the recording of business

transactions and the periodic reports on financial position and results of
operations.

Auditing is the examination of financial statements by an independent

auditor in order to express an opinion on the fairness of the presentation of the

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financial position, results of operation, and cash flows in conformity with
generally accepted accounting principles.
Government Accounting is concerned with the identification of sources
and uses of resources consistent with the provisions of city, municipal, provincial
or national laws.

Management Services is the processing of historical as well as projected

data of an entity to assist management in establishing plans for reasonable
economic objectives.

Tax Accounting encompasses the preparation of tax returns and

consideration of tax consequences of proposed business transactions.

Financial Management is concerned with the setting of financial

objectives, making plans based on those objectives, obtaining the funds needed
to achieve the plans, and generally safeguarding all the financial resources of
the entity.

Management Accounting incorporates cost accounting data and adopts

them for specific decisions which management may be called upon to make. A
management accounting system incorporates all types of financial and non-
financial information from a wide range of resources.

Users of Financial Information

Financial information is used by different groups for a variety of purpose

and reason. These users may be internal or external decision makers.

Internal decision makers are the owner(s)/managers responsible for

managing the resources of the firm. They have the power and authority to obtain
whatever economic information they need in evaluating the efficiency on the use
of resources. They are also interested on the result of operations and financial
condition as bases in the formulation of plans and policies.

External decision makers include those parties interested with the

financial information of a business but lack direct access to the information
generated by the internal operations. This includes the following:

Investors are concerned with the risk inherent in and the return
provided by their investments. They need information to help them
determine whether to invest, buy, hold or sell shares.

Employees are interested in information about the stability and

profitability of their employers. They need information which enables
them to assess the ability of the enterprise to provide them fair
remuneration, retirement benefits and other employment opportunities.

Creditors and suppliers are also interested in the financial

information for them to determine whether credit should be extended or
not.

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 Customers have interests in information about the continuance of
business operations, especially when they have long term involvement
with the firm or are dependent on the enterprise.

Government and their agencies require information in order to

regulate the activities of enterprises, determine taxation policies and as
basis for national income and similar statistics.

The Public need information about the trends and recent

developments in the prosperity of the enterprise and the range of its
activities.

Business Entity Concept

The most basic concept in accounting is the entity concept. An

accounting entity is an organization or a section of an organization that stands
apart from other organizations and individuals as a separate economic unit.
Transactions of different entities should be accounted for separately. In like
manner, the personality of the owner or owners of a business is separate and
distinct from that of the business, thus, transactions of the business should not
be combined with the owner’s personal transactions.

Accounting Cycle

The work to be done for each accounting period follows a uniform cycle,
which is composed of the following steps:

1. Identifying is the recognition of accountable events generally from the

source documents.

2. Journalizing is the recording of transactions in the book of original

entry, called the journal. The effects of the transactions on the
different accounts are analyzed and they are recorded chronologically
in the journal following generally accepted accounting principles.

3. Posting is the process of transferring the entries from the book of

original entry to the book of final entry, called the ledger. Each
account is assigned a general ledger, and as the accounts are
transferred from the journal to the ledger, they are sorted and
classified.

4. Preparing the Preliminary Trial Balance in order to provide a listing

to verify the equality of debits and credits in the ledger. After the
accounts are posted into the general ledger, the balances of the
different accounts shall be determined and then presented in the trial
balance showing the total debit balances and total credit balances.

5. Preparing the Adjusting Entries and the Worksheet to bring the

accounts up-to-date and accurate. Certain adjustments will have to be
journalized and posted at the end of the accounting period to record

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 (1) accrued expenses; (2) accrued income; (3) prepaid expenses;
(4) deferred or unearned income; (5) depreciation and (6) bad debts or
uncollectible accounts.

The preparation of a worksheet, however, is optional. It is done

to test the effects of the adjusting entries on the accounts before they
are formally recorded in the books. This is to also facilitate the
preparation of financial statements.

6. Preparing the Financial Statements which consists of the Balance

Sheet, Income Statement, Statement of Cash Flow and Statement of
Changes in Equity. The balance sheet shows the financial condition
of the business, while the income statement shows the results of
operation, whether the business made profits or incurred losses. The
cash flow statement shows the sources and uses of funds. The
statement of changes in equity shows reconciliations between the
carrying amounts at the beginning and the end of the period for each
component of equity.

7. Preparing the Closing Entries at the end of the accounting period to

bring the balances of income and expense accounts to zero. This is in
preparation for the next accounting period so as to be able to
distinguish income earned and losses incurred for one accounting
period. These entries are to be recorded in the general journal and
posted in the general ledger.
8. Preparing the Post-Closing Trial Balance to test the equality of the
accounts after the closing entries. While the preliminary trial balance
contains accounts that are presented in the balance sheet (real
accounts) and income statement (nominal accounts), the post-closing
trial balance presents only the accounts that are to be reflected in the
balance sheet in the next accounting period.

9. Preparing the Reversing Entries to simplify bookkeeping procedures

for certain regular transactions in the next accounting period. This is
done by reversing some adjusting entries to maintain the use of similar
methods or procedures in recording income and expenses. These
entries are to be recorded in the journal and posted in the ledger.

Basic Financial Statements

A. THE STATEMENT OF COMPREHENSIVE INCOME

It is a statement showing the performance of the business for a given

period of time. It summarizes the revenues earned and expenses incurred for
that period and communicates to the users its profitability status for a one-year
operation.

B. THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)

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 It is a statement that measures the financial position of the business in
terms of Assets, Liabilities and Owner’s Equity. It shows the resources (Assets)
employed by the business first, followed by the claim of the creditors (Liabilities)
against the assets, and then the claim of the owner called Capital.

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 C. THE STATEMENT OF CHANGES IN EQUITY

It presents the different elements that affect the equity of the owners
during a particular period. It also shows the changes in the equity structure of the
entity as it increases when at a profit and decreases when the business posted a
loss, or when additional investments and temporary withdrawals are made by the
owners.

D. THE STATEMENT OF CASH FLOWS

The statement of cash flows provides information about the cash receipts
and cash payments of an entity during a period. It is a formal statement that
classifies cash receipts (inflows) and cash payments (outflows) into operating,
investing and financing activities.

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