Comprehensive Notes on Introduction to Accounting and GAAP Principles

Foundations and Definitions of Accounting

• Accounting Standards Council (ASC) Definition of Accounting:

  • Accounting is a service activity.

  • Its function is to provide quantitative information, primarily financial in nature, about economic entities.

  • This information is intended to be useful in making economic decisions and in making reasoned choices among alternative courses of action.

• Role of the Accounting Standards Council (ASC):

  • Formulates, promulgates, and establishes Generally Accepted Accounting Principles (GAAP) in the Philippines.

• Historical Definition of Accounting:

  • Accounting is the art of recording, classifying, and summarizing, in a significant manner and in terms of money, transactions and events which are in part at least of a financial character, and interpreting the results thereof.

• Generally Accepted Accounting Principles (GAAP):

  • Represents the common set of accounting principles, standards, and procedures that govern how financial statements are prepared and presented.

Classification of Business Organizations by Operating Activity

• 1. Service Business:

  • Renders services to customers in exchange for a fee.

  • Operates by providing professional expertise, individual talents, or specialized skills to clients.

• 2. Merchandising Business:

  • Purchases finished goods or commodities and sells them at a profit.

  • The supply chain flow involves a seller purchasing finished goods and selling them to buyers in an unprocessed state.

  • Goods sold must remain unprocessed (sold as-is when purchased). If the goods undergo any transformation or processing, the business is reclassified as a manufacturing entity.

  • Primary examples include sari-sari stores and 7-Eleven retail convenience stores.

• 3. Manufacturing Business:

  • Produces finished goods starting from raw materials.

  • Operational transformation process: Raw Materials $\rightarrow$ Work in Process $\rightarrow$ Finished Goods $\rightarrow$ Buyer.

Basic Financial Statements and Account Classifications

• Five Basic Financial Statements:

  • 1. Balance Sheet / Statement of Financial Position: Presents the entity's Assets, Liabilities, and Owner's Equity as of a specific date.

  • 2. Statement of Comprehensive Income / Income Statement: Summarizes the entity's revenues and expenses for a given period to present the operating results.

  • 3. Statement of Changes in Equity / Capital Statement: Summarizes all changes in owner's equity that occurred during a specific period.

  • 4. Statement of Cash Flows: Provides information regarding cash receipts and cash payments over a period of time, categorized into operating, investing, and financing activities.

  • 5. Notes to Financial Statements: Presents narrative descriptions of significant accounting policies and explanatory notes impacting financial statement preparation.

• Classification of Accounts:

  • Real Accounts / Permanent Accounts:

  • Comprise Assets, Liabilities, and Owner's Equity.

  • End-of-period balances are carried over into the subsequent accounting period.

  • Nominal Accounts / Temporary Accounts:

  • Comprise Revenues and Expenses.

  • Balances are zeroed out at the conclusion of each accounting period.

Accounting Periods and Reporting Standards

• Reporting Frequency and Comparative Requirements:

  • In the Philippines, entities are legally required to prepare financial statements annually.

  • Annual financial statements must be comparative, presenting data for at least $2$ years.

  • Entities may optionally prepare financial statements monthly, quarterly, biannually, or daily based on internal discretion or operational needs.

• Types of Accounting Periods:

  • Calendar Year: An accounting period that begins on January 1 and ends on December 31.

  • Fiscal Year: An accounting period that begins on any day other than January 1 and ends 12 months later on any day other than December 31.

Illustrative Financial Statement: Comparative Income Statement

• Entity: ABC Company

• Statement: Income Statement

• Period: For the year ended December 31, 2025 (Comparative with December 31, 2024)

• Revenues:

  • Service revenues: $2025 = \text{P}848,000$ | $2024 = \text{P}672,000$

  • Commission revenues: $2025 = \text{P}62,000$ | $2024 = \text{P}40,000$

  • Total Revenues: $2025 = \text{P}910,000$ | $2024 = \text{P}712,000$

• Expenses:

  • Salaries expense: $2025 = \text{P}160,000$ | $2024 = \text{P}124,000$

  • Depreciation expense: $2025 = \text{P}20,000$ | $2024 = \text{P}20,000$

  • Repairs and maintenance expense: $2025 = \text{P}15,000$ | $2024 = \text{P}10,000$

  • Interest expense: $2025 = \text{P}8,600$ | $2024 = \text{P}7,500$

  • Rent expense: $2025 = \text{P}140,000$ | $2024 = \text{P}120,000$

  • Advertising expense: $2025 = \text{P}26,000$ | $2024 = \text{P}16,400$

  • Utilities expense: $2025 = \text{P}72,000$ | $2024 = \text{P}54,600$

  • Other expenses: $2025 = \text{P}18,600$ | $2024 = \text{P}12,400$

  • Total Expenses: $2025 = \text{P}460,200$ | $2024 = \text{P}364,900$

• Net Income (Loss):

  • $2025 = \text{P}449,800$

  • $2024 = \text{P}347,100$

The Five Elements of Financial Statements

• 1. Assets:

  • Resources controlled by the enterprise as a result of past transactions or events, from which future economic benefits are expected to flow to the enterprise.

  • Examples: Cash, Accounts Receivable, Notes Receivable, Merchandise Inventory, Prepaid Insurance, Prepaid Rent, Land, Building, Equipment, Automobiles, Machineries.

• 2. Liabilities:

  • Present obligations of the enterprise arising from past transactions or events, the settlement of which is expected to result in an outflow of resources embodying economic benefits.

  • Examples: Accounts Payable, Notes Payable, Mortgage Payable, Salaries Payable, Taxes Payable, Utilities Payable, Unearned Revenue.

• 3. Owner's Equity:

  • Represents the residual interest or claim of the owner on the assets of the business.

  • Examples (for Sole Proprietorships): Mr. A, Capital; Mr. A, Drawing.

• 4. Revenues:

  • Gross inflows of economic benefits during the period arising in the course of ordinary activities, representing the earnings of the entity.

  • Examples: Sales, Revenues, Professional Fees, Rent Income, Interest Income, Commissions Earned.

• 5. Expenses:

  • Gross outflows of economic benefits during the period incurred in the course of ordinary activities, representing costs incurred to produce revenue.

  • Examples: Salaries Expense, Rent Expense, Utilities Expense, Supplies Expense.

Legal Forms of Business Organization

• 1. Sole Proprietorship:

  • Owned by a single individual.

  • Easiest structure to organize.

  • Operations are less complicated, and administrative decisions are made faster due to single ownership.

  • Lacks a separate legal personality distinct from its owner.

  • Formation requires minimal legal filings.

  • Capital contribution is strictly limited to the owner's personal resources.

  • Management is performed directly by the owner.

• 2. Partnership:

  • An association of $2$ or more persons who bind themselves to contribute money, property, or industry to a common fund, with the intention of dividing profits among themselves.

  • Facilitates improved decision-making through multiple owners.

  • Lacks a separate legal personality distinct from the individual partners.

  • Formed by legal agreement among partners.

  • Capital contribution combines the joint resources of all partners.

  • Managed directly by designated managing partners.

• 3. Corporation:

  • An artificial being created by operation of law, possessing the right of succession and powers, attributes, and properties expressly authorized by law or incident to its existence.

  • Possesses a separate legal personality completely distinct from its owners.

  • Formed by operation of law and mandates formal statutory registration.

  • Capital is raised through the issuance of shares of stock to shareholders.

  • Ownership is vested in shareholders, while management is handled by an elected Board of Directors.

Professional Accounting Requirements

• Credential Requirements Across Accounting Sectors:

  • Public Accounting: Requires Certified Public Accountant (CPA) licensure.

  • Accounting Education: Requires Certified Public Accountant (CPA) licensure.

  • Government Accounting: Generally requires Certified Public Accountant (CPA) licensure. Exceptions exist where non-CPAs are permitted to hold accounting roles provided they have passed the civil service examinations, though CPA status remains the general standard.

Generally Accepted Accounting Principles (GAAP)

• Definition and Scope:

  • GAAP encompasses the conventions, rules, procedures, practices, and standards followed in accumulating, preparing, and presenting accounting data within financial statements.

  • Defines accepted accounting practice and acts as statutory rules for financial reporting.

• Underlying Accounting Assumptions:

  • Economic Entity Assumption: The business entity is separate and distinct from its owner(s) and from all other economic entities.

  • Going Concern Assumption: The business is assumed to continue operating indefinitely into the foreseeable future.

  • Monetary Unit Assumption: Only transaction data that can be quantified and measured in terms of money is recorded in the accounting records.

  • Time Period (Periodicity) Assumption: The economic life of a business can be divided into artificial time periods (such as monthly, quarterly, or yearly intervals).

• General Accounting Principles:

  • Historical Cost Principle: Assets are recorded and reported at their original acquisition cost.

  • Revenue Recognition Principle: Revenue is recognized and recorded when it is earned, regardless of when cash is received.

  • Matching Principle: Expenses must be recognized in the same period as the related revenues generated by those costs.

  • Full Disclosure Principle: All material information that could influence the economic decisions of financial statement users must be fully disclosed.

  • Consistency Principle: Accounting policies and methods must be applied consistently from one reporting period to the next.

  • Objectivity Principle: Accounting data and financial reports must be based on objective, verifiable evidence.

  • Conservatism (Prudence) Principle: When uncertainty exists, accounting treatments should select options that do not overstate assets or income.

  • Materiality Principle: Detailed accounting disclosure is strictly required only for items significant enough to impact or influence user decisions.

GAAP Application Scenarios and Practical Exercises

• Exercise 1 (Economic Entity Assumption):

  • Scenario: Mr. A, the owner of ABC Company, purchased a vehicle for his daughter's 18th birthday costing $\text{P}1,200,000$ and recorded the transaction in the accounting books of ABC Company.

  • Principle Application: Mr. A is incorrect. Under the Economic Entity Assumption, personal transactions of the owner must be kept strictly separate from the financial transactions of the business entity.

• Exercise 2 (Revenue Recognition and Matching Principles):

  • Scenario: DEF Company (owned by Mr. D) received $\text{P}300,000$ on December 29, 2008, from customer Mr. Z for mini boat repairs. Mr. D completed all repair work on January 7, 2009. Electricity and water costs incurred by Mr. D during the repairs totaled $\text{P}12,000$.

  • Principle Application: Revenue of $\text{P}300,000$ must be recorded in January 2009 when the service was fully performed and earned, not in December 2008 when cash was received. Related utility expenses of $\text{P}12,000$ must also be recognized in January 2009 to properly match expenses against the earned revenue.

• Exercise 3 (Conservatism / Prudence Principle):

  • Scenario: Mr. G, accountant for GHI Company, dealt with two transactions: On August 20, the company received $\text{P}2,000,000$ from the government for unclear purposes. On September 16, the company received $\text{P}500,000$ in repair services from XYZ Company, and Mr. G is uncertain if this should be recorded as an expense.

  • Part A Application: Applying conservatism/prudence, unearned or ambiguous cash inflows of $\text{P}2,000,000$ should not be recognized as income immediately, as doing so risks overstating income and assets.

  • Part B Application: Applying conservatism/prudence, the $\text{P}500,000$ service cost must be recorded as an expense to avoid understating liabilities or overstating net income.

• Exercise 4 (Historical Cost Principle):

  • Scenario: JKL Company was budgeting $\text{P}1,200,000$ for an office building. WWW Company listed land for $\text{P}1,400,000$ (appraised at $\text{P}1,500,000$). JKL Company negotiated and made an actual payment of $\text{P}1,300,000$ for the land.

  • Principle Application: Under the Historical Cost Principle, JKL Company must record the land in its accounting records at the actual agreed transaction acquisition cost of $\text{P}1,300,000$.

• Exercise 5 (Going Concern Assumption):

  • Scenario: ABC Company has suffered continuous losses over several years, struggles to pay debts, and faces cash shortages, but has not ceased operations.

  • Principle Application: Under the Going Concern Assumption, the accountant must continue recording transactions and preparing financial statements under the presumption that the business will remain operational, unless liquidation is imminent.

Qualitative Characteristics of Financial Information

• Fundamental Qualitative Characteristics:

  • Relevance: Financial information possesses relevance if it has the potential to make a difference in user decision-making.

  • Faithful Representation: Financial information must accurately and completely depict the real economic activity, events, or conditions it purports to represent.

• Enhancing Qualitative Characteristics:

  • Comparability: Enables users to identify and understand similarities and differences across reporting entities or across different time periods, supported by consistent reporting.

  • Verifiability: Assures users that independent and knowledgeable observers can reach a consensus that a representation is faithfully presented.

  • Timeliness: Requires financial information to be made available to decision-makers in time to influence their economic choices.

  • Understandability: Requires financial information to be classified, characterized, and presented clearly and concisely to facilitate user interpretation and evaluation.