Accounting for Non-Accountants

Lesson 1 – Introduction to Accounting

Module 1 – Introduction to Accounting

  • Accounting is a key function for almost any business, handled by bookkeepers or accountants in small firms, or sizable finance departments in larger companies.
  • Bookkeepers handle basic accounting, while Certified Public Accountants (CPAs) are utilized for more advanced tasks.
  • Reports from cost and managerial accounting are crucial for informed management decisions.
  • Accounting is necessary for decision making, cost planning, and economic performance measurement, regardless of business size.
  • Understanding accounting definitions, branches, history, principles, and standards is important.

Learning Outcomes:

  • Learning Objectives:
    • Understand the history and origin of accounting, including how it evolved.
    • Define accounting and relate its definition to the purpose of accounting information systems; identify primary uses of financial information.
    • Understand basic accounting principles to comprehend how the system works and how information is recorded and presented in financial reports.
    • Understand different types of businesses and forms of business organizations to distinguish them from each other.
    • Understand the basic accounting equation and its elements, as well as the account titles used in recording transactions.

What is Accounting?

  • Accounting is the process of recording financial transactions of a business.
  • The accounting process includes analyzing, recording, and summarizing financial transactions or events over an accounting period.
  • These transactions are reported in financial statements, such as the Income Statement, Balance Sheet, Capital Statement, and Statement of Cash Flows, to governmental regulatory and tax collecting agencies.
  • Accounting is how a business records, organizes, and understands its financial information.
  • It's like a machine processing raw financial information (records of transactions, taxes, estimates) to produce understandable reports about the financial state of the business.
  • These reports show whether the business is making a profit, the sources and uses of cash, the current assets and liabilities, and the owner's or owners' capital.

Technical Definitions of Accounting

  • American Institute of Certified Public Accountants (AICPA):
    • 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 financial character, and interpreting the results thereof."
  • American Accounting Association:
    • Accounting is “the process of identifying, measuring, and communicating economic information to permit informed judgment and decision by users of the information”.
  • Accounting Standards Council:
    • “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, in making reasoned choices among alternative courses of action.”

Branches of Accounting

  • Financial Accounting
  • Cost Accounting
  • Management Accounting
  • Auditing
  • Tax Accounting
  • Fund Accounting
  • Government Accounting
  • Forensic Accounting
  • Fiduciary Accounting

Detailed Explanation of Branches

  • Financial Accounting:
    • Systematic recording of transactions to produce Profit & Loss (P/L) statements and Balance Sheets.
    • Useful for creditors, banks, and financial institutions.
    • Provides an accurate picture of a company's financial position.
  • Cost Accounting:
    • Evaluates costs and calculates them by considering manufacturing and administrative factors.
    • Aims at price fixation and cost control.
    • Pinpoints wastages and leakages.
  • Management Accounting:
    • Aids in better administration and efficient decision making through Management Information Systems (MIS).
    • Includes Cost-Volume-Profit (CVP) and Break-Even Point (BEP) analysis.
    • Enhances profit and maintains secrecy of records.
    • Useful for creditors and shareholders.
  • Auditing:
    • Auditors inspect and certify accounts for accuracy.
    • Internal audits are also performed by company employees.
  • Tax Accounting:
    • Involves preparation and filing of tax returns.
    • Ensures compliance with tax laws.
    • Prepares tax reports and seeks to legally minimize taxes.
    • Includes verification and consideration of different aspects of taxes.
  • Fund Accounting:
    • Maintains records of funds for Non-Profit Organizations (NPOs).
    • Separate funds are maintained for different works to ensure proper usage.
  • Government Accounting:
    • Keeps records for central and state governments regarding allocations and utilization of various budgets.
    • Ensures proper usage of funds.
  • Forensic Accounting:
    • Calculates damages or settles disputes in legal matters.
    • Involves investigations and is also known as legal accounting.
  • Fiduciary Accounting:
    • Accounting and evaluation of a third party's business and property maintained under the care of another person.

Branches of Accounting - Expanded

  • Financial Accounting: Recording and categorizing transactions to generate GAAP-compliant financial statements. The data is historical.
  • Cost Accounting: A type of managerial accounting, commonly used in manufacturing, to assess a company’s operations. It records and analyzes manufacturing costs, fixed costs (e.g., rent), and variable costs (e.g., shipping).
  • Auditing:
    • External: Independent review of financial statements for GAAP/IFRS compliance.
    • Internal: Evaluation of accounting duties, authorization, procedures, and policies to prevent fraud, mismanagement, and waste.
  • Managerial Accounting: Provides data to managers for decision-making, including budgeting, forecasting, cost analysis, and financial analysis. Not strictly compliant with GAAP. Cost accounting is a subset.
  • Accounting Information Systems (AIS): Deals with accounting systems, processes, software management, and bookkeeping personnel.
  • Tax Accounting: Planning for tax minimization, payment schemes, and preparation of tax returns in compliance with tax regulations. It also analyzes tax-related business decisions.
  • Forensic Accounting: Focuses on legal affairs such as fraud inquiries, legal cases, and dispute resolution. It may involve reconstructing financial data and converting accounting systems.
  • Fiduciary Accounting: Centers on the management of property for another person or business, including estate accounting, trust accounting, and receivership.

Purposes and Uses of Accounting Information

  • Accounting accumulates and reports on financial information regarding a business's performance, position, and cash flows.
  • It provides information for stakeholders to make decisions about managing, investing in, or lending to the business.

Uses of Accounting Information

  1. Measuring Performance: Assessing business operations through financial statements and ratios, comparing them to industry standards.
  2. Creating Budgets: Using historical data to develop future budgets for financial planning.
  3. Making Business Decisions: Providing an overview of income and expenses for decisions like expansion, resource allocation, and new opportunities.
  4. Cost Analysis: Comparing the cost of resources to the potential income of new opportunities.
  5. Investment Decisions: Assisting external stakeholders like banks and investors to review financial health and profitability.

Accounting Principles

  • "Generally Accepted Accounting Principles" (GAAP) consists of:
    1. Basic accounting principles and guidelines
    2. Detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB)
    3. Generally accepted industry practices
  • Public companies must follow GAAP.
  • Financial statements must be audited by independent public accountants.
  • Management and independent accountants must certify that the financial statements are prepared in accordance with GAAP.

Key Accounting Principles and Guidelines

Accounting Assumptions:

  1. Money Unit
  2. Economic Entity
  3. Going Concern
  4. Time Period

Accounting Principles:

  1. Revenue Recognition
  2. Matching Principle
  3. Full Disclosure
  4. Historical Cost

Accounting Concepts:

  1. Materiality
  2. Conservatism
  3. Consistency
  4. Cost Benefit
  5. Objectivity

Accounting Constraints:

Ten Main Accounting Principles and Guidelines

  1. Economic Entity Assumption: Business transactions are kept separate from the owner's personal transactions, especially in sole proprietorships.
  2. Monetary Unit Assumption: Economic activity is measured in Philippine pesos, and only transactions expressible in pesos are recorded. The purchasing power of the peso is assumed to be constant; therefore, accountants ignore inflation.
  3. Time Period Assumption: Business activities can be reported in short time intervals (e.g., monthly, quarterly). Shorter intervals require more estimation. The time interval must be shown in the heading of financial statements.
  4. Cost Principle: "Cost" refers to the amount spent when an item was originally obtained. Financial statements show historical cost amounts, and asset amounts are not adjusted upward for inflation or increases in value. Current value of assets cannot be obtained from financial statements.
  5. Full Disclosure Principle: Important information must be disclosed in the financial statements or notes. This includes lawsuits and significant accounting policies.
  6. Going Concern Principle: Assumes the business will continue operating long enough to carry out its objectives and commitments. If not, this assessment must be disclosed. It allows the business to defer prepaid expenses.
  7. Matching Principle: Requires accrual basis accounting, matching expenses with revenues in the same period. (e.g., sales commissions expensed when sales are made, not when commissions are paid).
  8. Revenue Recognition Principle: Under accrual accounting, revenues are recognized when a product is sold or a service is performed, regardless of when money is received.
  9. Materiality: An amount that is insignificant may allow an accountant to violate another accounting principle. (e.g., expensing a 7,500 printer immediately instead of over five years). Financial statements often show amounts rounded to the nearest hundred, thousand, or million pesos.
  10. Conservatism: When two acceptable alternatives exist, the accountant chooses the one resulting in less net income and/or less asset amount. Accountants should be unbiased and objective, but conservatism is used to "break ties".
  • Conservatism leads accountants to anticipate/disclose losses, but not gains. (e.g., potential losses from lawsuits are reported, but not potential gains. Inventory is written down but not written up).

Accounting Standards

  • Accounting standards standardize and regulate accounting definitions, assumptions, and methods.
  • Consistency from year to year.
  • Reasonably confident conclusions from comparing companies.
  • Accounting standards has become more complex because financial transactions have become more complex.

Organizational Structure of Standard Setting Bodies:

  • IFRS Foundation
    • 22 Trustees
      • Appoint, oversee, raise funds.
    • Monitoring Board
      • Approve and oversee trustees.
    • IFRS Advisory Council
      • Approximately 40 members
      • Advise on agenda and priorities.
    • Accounting Standards Advisory Forum (ASAF)
      • Provide standard setter input into technical projects.
      • Working groups For major agenda projects.
  • IASB
    • Maximum 16 members
      • Set technical agenda; approve standards, exposure drafts, and interpretations.
      • IFRS Interpretations Committee
        • 14 members
          • Issue interpretations on the application of IFRS and develop other minor amendments.

IFRS (International Financial Reporting Standards)

  • The IFRS Foundation is a not-for-profit international organization responsible for developing a single set of high-quality, global accounting standards, known as IFRS Standards. IFRS Standards are set by the IFRS Foundation’s standard-setting body, the IASB.
  • The Monitoring Board is a group of capital market authorities and provides formal link between the Trustees and public authorities in order to enhance the public accountability of the IFRS Foundation.
  • The International Accounting Standards Board (IASB) is the independent standard- setting body of IFRS Foundation responsible for the development and publication of IFRS and for approving Interpretations of IFRS as developed by the IFRS Interpretations Committee.
  • The Trustees of the IFRS Foundation are responsible for the governance and oversight of the IASB, including the due process for the development of the accounting standards.
  • The IFRS Advisory Council provides advice and counsel to the Trustees and the Board, whilst the Board also consults extensively with a range of other standing advisory bodies and consultative groups.
  • The Accounting Standards Advisory Forum (ASAF) provides an advisory forum in which members can constructively contribute towards the achievement of the IASB’s goal of developing globally accepted high-quality accounting standards.
  • The IFRS Interpretations Committee is the interpretative body of the International Accounting Standards Board, which reviews implementation issues.

Forms of Business Organization

  • A business entity is a group of people organized for some profitable or charitable purpose.
  • The source of capital determines the form of business organization.
  • Business entities are subject to taxation and must file a tax return.
  • In the Philippines, the most common forms of businesses are sole proprietorships, partnerships, and corporations.

Business Organization Types Defined

  • Sole Proprietorship: Owned by an individual with full control of the business, owning all assets, being liable for all debts, and enjoying all profits. Must register with the Department of Trade and Industry (DTI).
  • Partnership: Under the Civil Code of the Philippines, it is treated as a juridical person, separate from its members. It can be general (partners have unlimited liability) or limited (limited partners have liability up to their capital contributions). Partnerships with more than Peso 3,000 capital must register with the Securities and Exchange Commission (SEC).
  • Corporation: Composed of juridical persons established under the Corporation Code and regulated by the SEC, with a separate personality from its stockholders. Shareholder liability is limited to their share capital. Requires 5-15 incorporators, each holding at least one share, and must be registered with the SEC. Minimum paid-up capital is Peso 5,000. Can be stock or non-stock, Filipino (60% Filipino-owned) or domestic foreign-owned (more than 40% foreign-owned).
    • Stock Corporation: Has capital stock divided into shares, authorized to distribute dividends from surplus profits.
    • One Person Corporation (OPC): A corporation with a single stockholder, who can only be a natural person of legal age, trust, or estate.
    • Non-Stock Corporation: Organized for public purposes like charitable, educational, or cultural reasons, and does not issue shares of stock.

Types of Business

  • Service Business
  • Merchandising Business
  • Manufacturing Business

Major Types of Businesses Distinguished

  • Service Business: Provides intangible products offering professional skills, expertise, and advice (e.g., salons, repair shops, schools, banks, law firms).
  • Merchandising Business: Buys products at wholesale prices and sells them at retail prices without changing their form (e.g., grocery stores, convenience stores, distributors).
  • Manufacturing Business: Buys products for use as materials in making a new product. It combines raw materials, labor, and overhead costs to produce goods (e.g. manufacturer that take raw material and creates widgets).

Financial Statements

  • Reports include Balance Sheet, Income Statement, Cash Flows, and Statement of Owner/s’ Equity (for sole proprietorship and partnership) or Shareholders’ Equity (for corporation).

Balance Sheet

  • A financial statement reporting a company's assets, liabilities, and shareholders' equity at a specific point in time.
  • Provides a basis for computing rates of return and evaluating capital structure.
  • Equation: Assets = Liabilities + Shareholders' Equity

Key Properties of an Asset

  • Ownership: Assets can be eventually turned into cash and cash equivalents.
  • Economic Value: Assets have economic value and can be exchanged or sold.
  • Resource: Assets can be used to generate future economic benefits.

Types of Asset Classification

  • Convertibility
    • Current Assets
    • Fixed Assets
  • Physical Existence
    • Tangible Assets
    • Intangible Assets
  • Usage
    • Operating Assets
    • Non-Operating Assets

Importance of Asset Classification

  • Understanding the net working capital of a company.
  • Assessing the solvency and risk of a company in a high-risk industry.
  • Understanding the contribution of revenue from each asset.
  • Determining what percentage of a company’s revenues comes from its core business activities.

Expanded Definitions - Asset Classifications

  • Classification of asset as to Convertibility:
    • How easy it is to convert them into cash.
    • Assets are classified as either current assets or fixed assets.
      • Short-term vs. long-term assets.
    • Current Assets:
      • Assets that can be easily converted into cash and cash equivalents (typically within a year).
      • Also termed liquid assets.
      • Examples:
        • Cash
        • Cash equivalents
        • Short-term deposits
        • Stock
        • Marketable securities
        • Office supplies
    • Non-Current Assets or Fixed Assets:
      • Assets that cannot be easily and readily converted into cash and cash equivalents.
      • Also termed fixed assets, long-term assets, or hard assets.
      • Examples:
        • Land
        • Building
        • Machinery
        • Equipment
        • Patents
        • Trademarks
  • Classification of asset as to Physical Existence:
    • Based on their physical existence
      • Tangible vs. intangible assets.
    • Tangible Assets:
      • Assets that have a physical existence (we can touch, feel, and see them).
      • Examples:
        • Land
        • Building
        • Machinery
        • Equipment
        • Cash
        • Office supplies
        • Stock
        • Marketable securities
    • Intangible Assets:
      • Assets that do not have a physical existence.
      • Examples:
        • Goodwill
        • Patents
        • Brand
        • Copyrights
        • Trademarks
        • Trade secrets
        • Permits
        • Corporate intellectual property
  • Classification of assets as to Usage:
    • Assets are classified as either operating assets or non-operating assets.
    • Operating Assets:
      • Assets that are required in the daily operation of a business.
      • Assets are used to generate revenue from a company’s core business activities.
      • Examples:
        • Cash
        • Stock
        • Building
        • Machinery
        • Equipment
        • Patents
        • Copyrights
        • Goodwill
    • Non-Operating Assets:
      • Assets that are not required for daily business operations but can still generate revenue.
      • Examples:
        • Short-term investments
        • Marketable securities
        • Vacant land
        • Interest income from a fixed or time deposit

Liabilities Defined

  • Defined by the International Financial Reporting Standards (IFRS) Framework: “A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

Classification of Liabilities

  • Current liabilities (short-term liabilities) are liabilities that are due and payable within one year.
  • Non-current liabilities (long-term liabilities) are liabilities that are due after a year or more.
  • Contingent liabilities are liabilities that may or may not arise, depending on a certain event.

Current Liabilities Expanded Upon

  • Debts or obligations that need to be paid within a year.
  • Management has to possess enough liquidity from current assets to guarantee that the debts or obligations can be met
  • Examples:
    • Accounts payable
    • Interest payable
    • Income taxes payable
    • Bills payable
    • Bank account overdrafts
    • Accrued expenses
    • Short-term loans
  • Metrics that management teams and investors use when performing financial analysis of a company
    • The current ratio: Current assets / Current liabilities
    • The quick ratio: (Current assets - Inventory) / Current liabilities
    • The cash ratio: (Cash and cash equivalents) / Current liabilities

Non-Current Liabilities Expanded Upon

  • Debts or obligations that are due in over a year’s time.
  • Important part of a company’s long-term financing.
  • Acquire immediate capital to fund the purchase of capital assets or invest in new capital projects.
  • Are crucial in determining a company’s long-term solvency.
    • Companies are unable to repay their long-term liabilities as they become due, then the company will face a solvency crisis.
  • List of non-current liabilities:
    • Bonds payable
    • Long-term notes payable
    • Deferred tax liabilities
    • Mortgage payable
    • Capital leases

Contingent Liabilities Expanded Upon

  • Liabilities that may occur, depending on the outcome of a future event.
  • Therefore, contingent liabilities are potential liabilities.
    • company is facing a lawsuit of P100,000, the company will incur a liability if the lawsuit proves successful.
  • In accounting standards, a contingent liability is only recorded if the liability is probable (defined as more than 50% likely to happen) and the amount of the resulting liability can be reasonably estimated.
    • Lawsuits
    • Product warranties

Capital Defined

  • Net assets or equity
  • Capital- what is left to the owners after all liabilities are settled
  • Capital = Total assets - Total liabilities
  • Capital is affected by the following:
    • Initial and additional contributions of owner/s (investments),
    • Withdrawals made by owner/s (dividends for corporations),
    • Income, and
    • Expenses.
  • Owner contributions and income increase capital. Withdrawals and expenses decrease it.
  • The terms used to refer to a company's capital portion varies according to the form of ownership.
    • sole proprietorship business
      • Owner's Equity or Owner's Capital
    • partnerships
      • Partners' Equity or Partners' Capital
    • corporations
      • Stockholders' Equity
  • Assets, Liabilities and Capital, there are two items that are also considered as key elements in accounting equation.
    • Income and expenses

Income

  • Income refers to an increase in economic benefit during the accounting period in the form of an increase in asset or a decrease in liability that results in increase in equity, other than contribution from owners.
    • Income encompasses revenues and gains.
  • Revenues refer to the amounts earned from the company’s ordinary course of business
    • professional fees or service revenue for service companies and sales for merchandising and manufacturing concerns.
  • Gains come from other activities
    • gain on sale of equipment, gain on sale of short-term investments, and other gains.
  • Income is measured every period and is ultimately included in the capital account.
    • Service Revenue, Professional Fees, Rent Income, Commission Income, Interest Income, Royalty Income, and Sales.

Expenses

  • Expenses are decreases in economic benefit during the accounting period in the form of a decrease in asset or an increase in liability that result in decrease in equity, other than distribution to owners.
  • Expenses include ordinary expenses
    • Cost of Sales, Advertising Expense, Rent Expense, Salaries Expense, Income Tax, Repairs Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss from Theft.
  • Like income, expenses are also measured every period and then closed as part of capital.
  • Net income refers to all income minus all expenses.

Income Statement

  • The income statement is the next financial statement everyone should look at.
  • Looks at Revenue and the expenses
  • Starts with the gross sales or revenue.
    • Deduct any sales return or sales discount from the gross sales to get the net sales.
  • From net sales, we deduct the costs of goods sold, and we get the gross profit.
  • From gross profit, we deduct the operating expenses
    • expenses required for daily administrative and selling expenses.
  • By deducting the operating expenses, we get the operating income.
  • From the operating income we add, if there is any, interest and other non-operating income received during the period and deduct the interest charges paid and other non-operating losses sustained during the period
    • we get the EBT, meaning Earnings Before Taxes.
  • From EBT, we deduct the income taxes for the period, and we get the Net Income or Net Profit, meaning profit after tax.

Cash Flow Statement

  • Cash Flow Statement is the third most important statement every investor should look at.

  • There are three separate segments of a cash flow statement.

    • Cash flow from the operating activities
    • Cash flow from investing activities
    • Cash flow from finance activities

  • Cash Flow from Operations is the cash generated from the core operations of the business.

  • Cash Flow from Investing Activities relates to the cash inflows and outflows related to investment in the company

    • Buying of property, plant, and equipment or other investments.

  • Cash Flow from Financing Activities relates to the cash inflows or outflows related to debt or equity of the company.

    • Raising of equity or capital, debt, loan repayments, buyback of shares, and similar financing activities.

Statement of Owner/Partners’ Equity

(FOR SOLE PROPRIETORSHIP AND PARTNERSHIP) OR STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY (FOR CORPORATION)

  • financial statement that provides a summary of changes in the owner/partners’ or shareholders’ equity in a given period.

Elements of Statement of Changes in Owner/Partners’ Equity/Capital

  • Capital or investment
    • Sum of cash acquired by a business to pursue its objectives, such as continuing or growing operations.
    • Permanent fixed assets such as property, plant, & equipment which ownership has been transferred to the business.
  • Net income
    • Equals is the amount remaining after subtracting all costs and expenses from revenue.
    • If the costs and expenses exceed revenue, it is called net loss and this is subtracted from the capital or investment.
  • Drawings or withdrawals
    • Amount of cash or non-cash items removed by the owner or partners from the business for personal use or expenditure.

Corporation - Elements of Statement of Changes in Stockholders’ Equity

  • Common Stock
    • Important part of shareholders’ equity.
    • Common stockholders are the owners of the company
      • There are corporations which issue preference shares which holders are also owners of the company but with limited rights.
  • Additional Paid in Capital
    • The company receives a premium on the shares.
    • Premium results when the shares of stock are issued above par value.
  • Retained earnings or losses
    • Are accumulated from the previous period.
    • Amount the company keeps after paying the dividend from net income.
  • Treasury shares
    • Sum total of all the common shares that have been purchased back by the company.
  • Dividend
    • Distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors.