Chapter 2 - from Zeus Vernon B. Millan. PDF

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Headline Title Classification/Enumeration Stressed Out/Important details Meaning Example Additional info not from the book Accounting Concepts and Principles Accounting concepts and principles (assumptions or postulates) are a set of logical ideas and procedures that guide the accountant in recording and communicating economic information. They provide a general frame of reference by which accounting practice can be evaluated and they serve as guide in the development of new practices and procedures. Accounting concepts and principles provide reasonable assurance that information communicated to users is prepared in a proper way. For example, doctors have a proper way of performing surgery on a patient; engineers have a proper way of constructing a bridge; accountants too have a proper way of recording and communicating economic information. This is to maximize the usefulness of accounting information to the users. Basic Accounting Concepts There are numerous concepts and principles used in accounting. These are sourced from the Standards (PFRSs), the Conceptual Framework for Financial Reporting, or general acceptance in the profession due to long-time use. Accounting is constantly changing and new concepts are continuously emerging. It is, therefore, not practicable to list all the concepts and principles used in accounting. Only some Of the basic and most common accounting concepts and principles are listed below. I. Separate entity concept — Under this concept, the business is viewed as a separate person, distinct from its owner(s). Only the transactions of the business are recorded in the books of accounts. The personal transactions of the business owner(s) are not recorded. For example, you started a business. Under the separate entity concept, you will view your business as a separate person, like a friend maybe.@d (Your business can also have its own Facebook account.)

Therefore, the money you invested to the business is now owned by the business. It is not your personal money anymore. Also, the business owns any money that it earns. If you take money from the business for your personal use, it would be recorded in the books of accounts as a withdrawal of your investment from the business. Similarly, when you take goods from the business for your personal consumption which you don't intend to pay, this would also be recorded as a withdrawal of your investment. Your personal transactions (i.e., those that do not involve the business) are not recorded in the books of accounts. For example, using your personal money to buy groceries for home consumption is not recorded in the books of accounts. The application of the separate entity concept is necessary so that the financial position and financial performance of a business can be measured properly. By applying the separate entity concept, you can objectively know if the business is really earning profits, or if it has the ability to do so. Many businesses have failed because they did not apply the separate entity concept. Take for example an owner Of a sari-sari store who regards the store's cash register as an extension of his pocket. He takes money from the business for personal use and consumes the store's goods without recording them. The business then suffers from lack Of working capital. It runs out of goods to sell without any money to replenish them. Eventually, the business becomes bankrupt. Unknowingly, this guy has caused his own business to fail. If this guy had applied the separate entity concept, he would have had better accounting information that could have led him to make better business decisions. 2. Historical cost concept (Cost principle) — Under this concept, assets are initially recorded at their acquisition cost. The amount that is originally paid to acquire the asset and may be different from the current market value of the asset. Let us assume, for example, that a herbal medicine company purchases a piece of land for growing herbs on it, paying $25,000 in cash. The company will enter $25,000 as the cost of the land in its accounting records. An important advantage of historical cost concept is that the records kept on the basis of it are considered consistent, comparable, verifiable and reliable.

Any valuation basis other than historical cost may create serious issues for companies. For example, if a company uses current market value or sales value rather than historical cost, each member of accounting department is likely to suggest a different value for each asset of the company.

3. Going concern assumption — Under this concept, the business is assumed to continue to exist for an indefinite period of time. This is necessary for accounting measurements to be meaningful. For example, measuring assets at historical cost (historical cost concept) is appropriate only when the business is a going concern. The opposite of going concern is liquidating concern. This is the case if the business intends to end its operations or if it has no other choice but to do so, (e.g., the business is bankrupt). The assets of a liquidating concern are measured at net selling price rather than at historical cost. (Going concern — good SO; Liquidating concern — bad ). 4. Matching (or Association of cause and effect) — Under this concept, some costs are initially recognized as assets and charged as expenses only when the related revenue is recognized. requires that revenues and any related expenses be recognized together in the same reporting period. Thus, if there is a cause-and-effect relationship between revenue and certain expenses, then record them at the same time. If there is no such relationship, then charge the cost to expense at once. This is one of the most essential concepts in accrual basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting period. 5. Accrual Basis of accounting — Under the accrual basis of accounting, economic events are recorded in the period in which they occur rather than at the point in time when they affect cash. Thus, income. is recognized in the period when it is earned rather than when it is collected, while expense is recognized in the period when it is incurred rather than when it is paid. 6. Prudence (or Conservatism) — Under this concept, the accountant observes some degree of caution when exercising judgments needed in making accounting estimates under conditions of uncertainty. Such that, if the accountant needs to choose between a potentially unfavorable outcome versus a potentially favorable outcome, the accountant chooses the unfavorable one. This is necessary so that assets or income are not overstated and liabilities or expenses are not understated.

7. Time Period (Periodicity, Accounting period, or Reporting period concept) — Under this concept, the life of the business is divided into series of reporting periods. A financial accounting principle that assumes all companies and organizations can divide activities into time periods. These time periods are often called accounting and reporting time periods and can be weekly, monthly, semi-annually, annually, or any other time interval. Anecdote A grocery store owner from the old country kept his accounts payable on a spindle, accounts receivable on a note pad, and cash in a cigar box. His daughter. having just passed the CPA exam. chided the father: "l don't understand how you can run your business this way. How do you know what your profits are?" "Well," the father replied, "when I got off the boat forty years ago, I had nothing but the pants I was wearing. Today your brother is a doctor, your sister is a college professor, and you are a CPA. Your mother and I have a nice car, a well-furnished house, and a lake home. We have a good business, and everything is paid for. So, you add all that together, subtract the pants, and there's your profit." (Hospitality Financial Accounting by Jerry J. Weygandt, et. al. 2005 John Wiley & Sons, Inc.) The business owner may be right. However, it would be impractical to wait so long to determine the financial performance of a business. Users need timely periodic information to help them make economic decisions. Managers need periodic information on the results of operations for them to properly perform their functions. For example, managers may need to know the following: 

Which products or services are selling well and which are

not? Is the business spending too much on expenses? Does the business need to cut down costs?  Is the business generating enough cash from its operating activities? 

External users may need to know the following: For creditors: Is the business generating enough cash needed to pay its maturing liabilities? For investors: Is the business earning enough profits to ensure future growth? For the government: Is the business paying the right taxes?

Thus, instead of waiting until the life of the business ends before profit is determined, the life of the business is divided into series of equal short periods called reporting periods (or accounting periods). A reporting period is usually 12 months, although it can be longer or shorter. A 12-month accounting period is either a calendar year period or a fiscal year period. A calendar year period starts on January 1 and ends on December 31 of the same year. A fiscal year period also covers 12 months but starts on a date other than January I, e.g., July 1, 2019 to June 30, 2020. An accounting period that is shorter than 12 months is called an "interim period." An interim period can be a month, a quarter (3 months) or a semiannual period (6 months). 8. Stable monetary unit — Under this concept, assets, liabilities, equity, income and expenses are stated in terms of a common unit of measure, which is the peso in the Philippines. Moreover, the purchasing power of the peso is regarded as stable. Therefore, changes in the purchasing power of the peso due to inflation are ignored. Because of this assumption, past financial statements are usually not updated even if the value of money substantially changes 9. Materiality concept — This concept guides the accountant when applying accounting principles. This is because accounting principles are applicable only to material items. An item is considered material if its omission or misstatement could influence economic decisions. Materiality is a matter of professional judgment and is based on the size and nature of an item being judged. For example, material items are communicated to users in a more detailed manner as compared to immaterial items. Another example is that big companies often round-off amounts in their financial reports. An account with a balance of P323,487,679,621.21 may be reported as P323,488 with an indication of the level of rounding-off as (in '000,000s), meaning "in millions." Since the company is big (nature), the amount of P679,621.21 (size) is considered immaterial. Rounding-off this amount would not affect the decision making of the users.

You may also think of materiality this way. You go to a store to buy some stuff worth P99.90, which you pay using a PIOO.OO bill. The cashier tells you that she has no PO. 10 to give you as change. Will you get mad? I hope not. Most likely, you will just smile and tell her to keep the change. This is because PO.IO is most likely to be immaterial to you. It should be noted though that rounding-off of amounts is acceptable only when preparing financial reports. The accountant does not omit amounts (even centavos) when recording in the books of accounts. Accounting principles do not specify a certain amount that is considered material — this is a matter of professional judgment and depends on the facts and circumstances surrounding the entity (e.g., what is material to you might be immaterial to others, and vice-versa). 10. Cost-benefit (Cost constraint) — Under this concept, the costs Of processing and communicating information should not exceed the benefits to be derived from the information's use. the cost of providing information via the financial statements should not exceed its utility to readers. The essential point is that some financial information is too expensive to produce. Arises when it is excessively expensive to report certain information in the financial statements. When it is too expensive to do so, the applicable accounting frameworks allow a reporting entity to avoid the related reporting. The intent of allowing the cost constraint is to keep businesses from incurring excessive costs as part of their financial reporting obligations, especially in comparison to the benefit obtained by readers of the financial statement Il. Full disclosure principle — This concept is related to both the concepts of materiality and cost-benefit. Under the full disclosure principle, information communicated to users reflect a series of judgmental trade-offs that strive for: a. Sufficient detail to disclose matters that make a difference to users, yet b. Sufficient condensation to make the information understandable, keeping in mind the costs of preparing and using it. 12. Consistency concept — This concept requires a business to apply accounting policies consistently, and present information consistently, from one period to another. This means that like transactions must be accounted for in like manner.

Accounting policies used this year shall be the same accounting policies used last year. This, however, does not mean that a business cannot change its accounting policies. Accounting policies can be changed if it is required by a standard or the change would result in more relevant and more reliable information. Any change in accounting policy must be disclosed. LD Summary: Basic Accounting Concepts 1. Separate entity concept 2. Historical cost concept 3. Going concern assumption 4. Matching 5. Accrual Basis 6. Prudence (or Conservatism) 7. Time Period 8. Stable monetary unit 9. Materiality concept 10. Cost-benefit 11. Full disclosure principle 12. Consistency concept Application of the Basic Accounting Concepts During the year. you started a business of selling personalized mugs and T-shirts. You opened a separate bank account for the business and deposited your initial investment of P250.OOO to this account. (Separate entity concept) The business acquired a printing machine. The regular selling price is P 100.000; however. you were able to acquire it at a discounted price of P90,OOO. You will record the machine at its acquisition cost of P 90.000 rather than at the regular selling price. (Historical cost concept) The business acquired initial inventory of mugs and T-shirts for a total cost of P50,OOO. You will record the cost as an asset (i.e., inventory) rather than as expense. (Matching concept) All the inventory was sold on credit* for P 300,000 (Vtold on credit' means 'pinautang' in Filipino). You will immediately record the credit sales as accounts receivable* rather than waiting for them to be collected ('Éccounts receivable' means 'listahan ng mga pinautang' in Filipino). (Accrual basis) Also, you will now record the P50,OOO cost of the inventory as expense. (Matching concept)

You collected P290,OOO out of the P300,OOO total credit sales. You will deposit the collections to the bank account of the business rather than to your personal account (Separate entity concept). The debtor* for the remaining PIO,OOO is in financial difficulty ("debtor' means 'taong umutang' in Filipino). This has raised doubt on whether he can pay his account. You will immediately recognize the doubtful account as expense. (Prudence or Conservatism and Accrual basis) You withdrew cash of P80,OOO from the business for your personal use. You will record this transaction as a withdrawal of your investment from the business rather than a business expense. (Separate entity concept) At the end of the year, you prepared the financial statements of your business to determine, among others. whether the business has earned profit. (Time period) When preparing the financial statements. you discovered that the business has $10 (dollars). You will translate this to Philippine peso using the current exchange rate. The amount that you will report in the financial statements is the translated amount. (Stable monetary unit) Also, you have found out that the regular selling price Of a new printing machine increased from P 100.000 to P120,OOO. You will ignore this information (Stable monetary unit) and report the printing machine at its acquisition cost of P90,OOO in the financial statements (Historical cost). This is because you don't intend or expect to close your business in the foreseeable time (Going Concern). During the year. the business bought a trash bin for P80. You expect to use this over several years. However, because you deemed the cost as immaterial, you will record this as an expense rather than an asset. (Materiality) Moreover, when you prepared the financial statements, you decided to include the cost of the trash bin in a "Miscellaneous Expenses" account together with other immaterial expenses. You don't expect users of the finiancial statements to benefit from reporting the immaterial cost separately. (Cost-benefit) You will make a brief description of the "Miscellaneous Expenses" account in the notes to financial statements, sufficient for users to understand the nature of this account. (Full disclosure) You then adopted an accounting policy of expensing outright

all acquisitions of equipment costing P5,OOO and below. You will apply this policy consistently in the future periods. (Consistency) Accounting standards Accounting concepts and principles are either explicit or implicit. Explicit concepts and principles are those that are specifically mentioned in the Conceptual Framework for Financial Reporting and in the Philippine Financial Reporting Standards (PFRSs). Implicit concepts and principles are those that are not specifically mentioned in the foregoing but are customarily used because of their general and longtime acceptance within the accountancy profession. The terms "standards," "principles," "concepts," "assumptions" and "postulates" are used interchangeably in practice. However, the term "standards" is used to specifically refer to the Philippine Financial Reporting Standards (PFRSs). Traditionally, accounting standards were referred to as the generally accepted accounting principles (GAAP).

Philippine Financial Reporting Standards (PFRSs) The Philippine Financial Reporting Standards (PFRSs) are Standards and Interpretations adopted by the Financial Reporting Standards Council (FRSC). They consist of the following: a. Philippine Financial Reporting Standards (PFRSs); b. Philippine Accounting Standards (PASS); and c. Interpretations Just like the basic accounting concepts, the standards serve as guide when recording and communicating accounting information. The difference is that the standards provide a more detailed application of concepts. They also prescribe which principle is most appropriate for specific economic transactions. They also require certain information that should be included in financial reports and how this information is presented. You may think of the difference between basic concepts and standards this way — a basic concept would be like "you need to brush your teeth daily." On the other hand, a standard would prescribe a proper way of brushing your teeth, how many times should you brush in a day, and it may even suggest a certain toothbrush that is best for you. (0...