Fundamental Concepts and Principles of Accounting

Fundamental Concepts Underlying the Accounting Process

• Entity Concept: An accounting entity is defined as an organization, or a section of an organization, that stands apart from other organizations and individuals or acts as a separate economic unit. Simply put, the transactions of different entities should not be accounted for together. Each entity must be evaluated separately.
• Periodicity Concept: An entity's life can be meaningfully subdivided into equal time periods for reporting purposes. It is considered aimless to wait for the actual last day of an entity's operations to perfectly measure its net income. This concept allows users to obtain timely information to serve as a basis for making decisions about future activities. For the purpose of reporting to outsiders, one year ($1\,year$) is the usual accounting period.
• Stable Monetary Unit Concept: The Philippine Peso is considered a reasonable unit of measure with a relatively stable purchasing power. This allows accountants to add and subtract peso amounts as though each peso possesses the same purchasing power as any other peso at any time. This concept serves as the basis for ignoring the effects of inflation in accounting records.
• Accrual Basis: Accrual accounting depicts the effects of transactions and other events and circumstances on a reporting entity's economic resources and claims in the period in which those effects occur, even if the resulting cash receipts and payments occur in a different period.

Generally Accepted Accounting Principles (GAAP)

• The Need for GAAP: Adherence to proper accounting rules makes financial statements meaningful and useful, regardless of the type of business organization. The various needs for reliable financial statements can only be satisfied if there are rules, procedures, and principles of accounting that are generally accepted and used.
• Basis for Comparison: If each entity made up their own rules, there would be no basis for comparing the earnings and financial position of different firms. Furthermore, the records and reports of a particular entity could not be compared across different periods unless accounting principles are applied consistently. Without GAAP, users of financial statements would likely be misinformed and misled.
• Development of GAAP:
  • A particular procedure may be devised by an accountant as a solution to a specific problem.
  • Other accountants may then find the procedure suitable for their own problems and begin using it.
  • Eventually, the procedure may become widely used and recognized by professional accountants, accounting writers, and organizations responsible for developing GAAP.
  • Other principles result from decisions by authoritative, rule-making bodies such as the Accounting Standards Council (ASC)/International Accounting Standards Committee (IASC) and the Financial Reporting Standards Council (FRSC)/International Accounting Standards Board (IASB) to select one of several alternative methods used in practice.
  • In some cases, rule-making bodies develop standards based on logic or deductive reasoning when no clearly defined practices exist for certain types of transactions or events.
• Evolution of Principles: Businesses and the environment (economy, technology, and laws) are constantly changing. Therefore, financial information and presentation methods must change to meet the needs of users. GAAP is refined as accountants respond to these changing environments.

Criteria for General Acceptance of an Accounting Principle

• Relevance: A principle has relevance to the extent that it results in information that is meaningful and useful to those who need to know something about a certain organization.
• Objectivity: A principle has objectivity to the extent that the resulting information is not influenced by the personal bias or judgment of those who furnish it. Objectivity connotes reliability, trustworthiness, and verifiability (the ability to find out whether information is correct).
• Feasibility: A principle has feasibility to the extent that it can be implemented without undue complexity or cost.
• Conflict of Criteria: These criteria often conflict; for instance, the most relevant solution may be the least objective and the least feasible.

Basic Principles of Accounting

• Objectivity Principle: Accounting records and statements are based on the most reliable data available to ensure they are as accurate and useful as possible. Reliable data are verifiable when they can be confirmed by independent observers. Ideally, records flow from activities documented by objective evidence rather than whims or opinions.
• Historical Cost: This principle states that acquired assets should be recorded at their actual cost rather than what management thinks they are worth at the reporting date.
• Revenue Recognition Principle: Revenue is to be recognized in the accounting period when the goods are delivered or services are rendered or performed.
• Expense Recognition Principle: Expenses should be recognized in the accounting period in which goods and services are used up to produce revenue, rather than when the entity pays for those items.
• Adequate Disclosure: This requires that all relevant information that would affect the user's understanding and assessment of the accounting entity be disclosed in the financial statements.
• Materiality: Financial reporting is concerned only with information significant enough to affect evaluation and decisions. Materiality depends on the size and nature of the item judged within the particular circumstances of its omission. Either the nature or the size of an item (relative to the firm) could be the determining factor.
• Consistency Principle: Firms should use the same accounting method from period to period to achieve comparability over time within a single enterprise. Changes are permitted only if they are justifiable and disclosed in the financial statements.

Conceptual Framework for Financial Reporting

• Scope of the Revised Conceptual Framework:
  • The objectives of financial reporting.
  • Qualitative characteristics that determine the usefulness of information.
  • Financial statements and the reporting entity.
  • Definition, recognition, de-recognition, and measurement of financial statement elements.
  • Presentation and disclosures.
  • Concepts of Capital and Capital maintenance.
• Objectives of Financial Reporting: To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions relating to providing resources to the entity. These decisions involve:
  • Buying, selling, or holding equity and debt instruments.
  • Providing or settling loans and other terms of credit.
  • Exercising rights to vote on or influence management's actions affecting the use of economic resources.

Qualitative Characteristics of Useful Information

• Fundamental Qualitative Characteristics: These are essential to make information useful.
  • Relevance: Information is relevant if it is capable of making a difference in user decisions. This is true if it has predictive value (can be used as an input to predict future outcomes) or confirmatory value (provides feedback about previous evaluations).
  • Materiality: Information is material if omitting it or misstating it could influence decisions made on the basis of financial info.
  • Faithful Representation: Information must faithfully represent the phenomena it purports to represent. This seeks to maximize completeness, neutrality, and freedom from error.
    • Completeness: Includes all necessary descriptions and explanations, such as numerical depictions of assets and descriptions of what those numbers represent (e.g., historical cost).
    • Neutrality: The depiction is not slanted, weighted, emphasized, or de-emphasized to manipulate user reception. Neutrality is supported by prudence (exercise of caution so that assets/income are not overstated and liabilities/expenses are not understated).
    • Freedom from Error: No errors or omissions in the reported information or the description of transactions. This does not mean perfectly accurate in all respects, but that the process applied was appropriate.
• Enhancing Qualitative Characteristics: These improve the usefulness of information that is already relevant and faithfully represented.
  • Comparability: Enables users to identify and understand similarities and differences among items. It requires at least two items for comparison. Consistency (using the same methods) is the means used to achieve the goal of comparability.
  • Verifiability: Helps assure users that information faithfully represents economic phenomena. It means different knowledgeable and independent observers could reach a consensus (not necessarily complete agreement).
  • Timeliness: Information is available to decision-makers in time to be capable of influencing their decisions.
  • Understandability: Classifying, characterizing, and presenting information clearly and concisely. Reports are prepared for users with a reasonable knowledge of business and economic activities.
• Applying Enhancing Characteristics: These should be maximized, but they cannot make information useful if that information is irrelevant or not faithfully represented.
• Cost Constraint: The benefits of reporting information should justify the costs of providing it. Only information with benefits of disclosure greater than the costs of providing it need be disclosed.

Underlying Assumption and Financial Statements

• Going Concern: Financial statements are prepared assuming an enterprise will continue in operation for the foreseeable future, having neither the intention nor the necessity of liquidation or material curtailment of operations. This is the basis for depreciating assets over their useful lives. If liquidation is expected, assets are valued at liquidation worth instead of original cost.
• Objective of Financial Statements: To provide information about an entity's financial position, performance, and cash flows to a wide range of users for economic decision-making.
• Complete Set of Financial Statements:
  • 1. Statement of Comprehensive Income for the period.
  • 2. Statement of Changes in Equity for the period.
  • 3. Statement of Financial Position as at the end of the period.
  • 4. Statement of Cash Flows for the period.
  • 5. Notes (summary of significant accounting policies and explanatory information).
  • 6. Statement of Financial Position as at the beginning of the earliest comparative period if an entity applies a policy retrospectively, makes a retrospective restatement, or reclassifies items.

Elements, Recognition, and Measurement

• Elements of Financial Statements:
  • Financial Position (Balance Sheet): Assets, liabilities, and equity.
  • Performance (Income Statement): Income and expenses.
• Recognition: The process of capturing an item for inclusion in the statement of financial position or performance statements.
• Derecognition: The removal of all or part of a recognized asset or liability from the statement of financial position.
• Measurement Bases: Elements are quantified in monetary terms choosing a specific basis:
  • Historical Cost: Information derived from the price of the transaction/event. For assets, it is the cost of acquisition/creation. For liabilities, it is the value of consideration received. These values are updated over time for consumption, fulfillment, impairment, or onerous status.
  • Current Value: Provides monetary information updated to reflect conditions at the measurement date. This includes Fair Value, Value in Use (assets), Fulfillment Value (liabilities), and Current Cost.