LESSON 2:

INTRODUCTION
TO ACCOUNTING

ACCOUNT1: Fundamentals of
Accounting (Part 1)
 Overview of Lesson 2
• Forms of Business Organizations
• Definition and Purpose of Accounting
• Users of Accounting Information
• Financial Statements
• Accounting Concepts and Principles
• Definition and Classification of Assets,
Liabilities, Equity, Income and Expenses
• Normal Balances
Business Organizations
 What is a Business?
• A business (also known A business can be:
as enterprise or firm) is • Profit-oriented: earns
an organization engaged profit to increase the wealth
in the trade of goods, of the owners
services or both to • Non-profit oriented: uses
consumers surplus revenues to
achieve its goals instead of
distributing them as profit
to owners
 Forms of Business Organizations
Nature of Business Legal Forms of Ownership:
• Service • Sole Proprietorship
• Merchandising/Trading • Partnership
• Manufacturing • Corporation
 Service Business
• Offers professional services and generates a profit by
charging a fee.
• Schools generate profit by charging tuition fees. Airlines
generate profit by collecting airfares.
• Examples: accountants, doctors, lawyers, architects,
real estate brokers, consultants
 Merchandising/Trading
• Buys goods and sells them in their original form.
Charges customers a profit mark-up.

• Examples: groceries, drugstores

 Manufacturing
• Buys raw materials, converts these raw materials into
finished products and sells/distributes them at a profit

• Difference with merchandising: conversion process.

Most complex among service and merchandising

• Examples: car manufacturing

 Sole/Single Proprietorship
• Has 1 owner called proprietor. Most basic legal form of business

Advantages: Disdvantages:
• Easiest to form and less complex • Limited ability to raise capital
business transactions • Limited resources and skills
• Minimal regulatory requirements • Bears all the risks and losses of
• Complete control of the business the business
and enjoys all the profits • Limited life
• Unlimited personal liability:
personal property may be used
to satisfy obligations of business
creditors
 Partnership
• Association of 2 or more persons (called partners), who bind
themselves to contribute money, property or industry to a
common fund, with the intention of dividing the profits among
themselves.

• Partnerships are governed by Civil Code of the Philippines

• Partners agree the capital contributions, manner of business

management, profit distribution and mode of settlement in case of
dissolution and liquidation.
 Advantages and Disadvantages of
Partnership
Advantages: Disadvantages:
• Easier to organize • Plurality of owners may
compared to corporation result to disagreement
• Brainstorming (2 heads are • Limited life
better than 1) • Unlimited personal
• Can raise more capital liability of partners:
compared to sole personal property may be
proprietorship used to satisfy obligations
of business creditors
 Corporation
• Most complex form of business organization

• artificial being created by operation of law, having the right of

succession and the powers, attributes and properties expressly
authorized by law or incident to its existence (Corporation Code)

• A person who invests and becomes an owner of the corporation is

called a shareholder/stockholder

• Ownership in the corporation is divided

into smaller units called shares/stocks
 Advantages and Disadvantages of
Corporation
Advantages: Disadvantages:
• Greatest capacity to raise • More difficult and expensive
capital by selling shares or to organize and form
bonds and borrowing from • Subject to greater
banks government regulations
• More resources • Subject to more/higher
• Shares can be transferred taxes
without the consent of all the
shareholders
• Unlimited life
• Limited liability of the
shareholders (owner’s point of
view)
Definition and Purpose
of Accounting
 Decision-Making

Non-
financial
information

Business
(economic
entity)

Financial
information
 What is Accounting?
• 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 is the art of recording, classifying, 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.
 Purpose of Accounting
• To supply financial information to users to help them make
informed judgments and better decisions
 Accounting as the Language of Business
• Accounting is the language used
to communicate financial
information to interested parties
such as business owners,
management, employees and the
government.

• Through accounting, different

users of financial information
understand what is happening in
the business
 Difference between Accounting and
Bookkeeping
• Bookkeeping is the procedural or mechanical aspect of
accounting. It involves set-up, update and maintenance of
accounting records.

• Accounting is conceptual and goes beyond bookkeeping. It

includes interpretation of information recorded under
bookkeeping.

• Bookkeeping is the procedural part of accounting.

Users of Accounting
Information
 Users of Accounting Information
Direct Users: • Indirect Users
• Owners/Investors • Stock exchange
• Managers • Trade associations
• Lenders/Creditors • Regulatory bodies
• Suppliers (e.g. Philippine Stock
• Government Exchange)
• Employees • Financial analysts
• Customers
 Users of Accounting Information

Owner/Investors:
 One who puts in money or property (capital) in a
business venture with the objective of making his money
or capital grow from the profits earned by the business.
 Users of Accounting Information

Managers:
 In order to evaluate the manager’s quality of
management and stewardship
 Users of Accounting Information

Lenders/Creditors:
 In order to assess the business’ ability to pay its debt
(principal + interest) on time
 Users of Accounting Information

Suppliers:
 In order to evaluate the business’ ability to pay its
obligations after delivering the goods to them.
 Users of Accounting Information

Government
 Bureau of Internal Revenue (BIR): to assess the
correctness of tax returns and taxes to be paid

 Securities & Exchange Commission (SEC): to check on

corporations compliance to rules and regulations.
 Users of Accounting Information

Employees
 In order to evaluate the ability of the Company to grant
employees’ remuneration, benefits, good working
conditions, security.
 Users of Accounting Information

Customers
 In order to assess the company’s continuous supply of
goods at right price and good quality
Fields of Accounting
 Fields/Kinds of Accounting
• Financial Accounting: focuses on the preparation and
presentation of general-purpose financial statements with the aim
of meeting most of the needs of external users.

• Management Accounting: concerned primarily with financial

reporting for internal users such as management.

• Cost Accounting: measures a business’ costs to help

management in controlling expenses.
 Fields/Kinds of Accounting
• Tax Accounting: aims at complying with the tax laws and
minimizing company’s tax bill through legal means. Accountants
provide tax planning and tax consultancy services such as giving
advise to clients.

• Government Accounting: encompasses the process of

analyzing, classifying, summarizing and communicating all
transactions involving the receipt and disposition of government
funds and property and interpreting the results thereof. In other
words, government accounting is the proper custody,
disposition and accounting for public funds.
Financial Statements
 Financial Statements

• Financial statements are the means by which the information

accumulated and processed in financial accounting is periodically
communicated to the users.

• End product of financial accounting

 Financial Statements

A complete set of financial statements consist of the following:

• Balance Sheet (Statement of Financial Position)

• Income Statement (Statement of Comprehensive Income)
• Statement of Changes in Equity
• Statement of Cash Flows
• Notes to Financial Statements
 Income Statement

• Income Statement shows the financial performance, profitability

or results of operations (i.e. net income, net loss or break-even) of
a company for a given period.
– Income > Expenses  Net Income
– Income < Expenses  Net Loss
– Income = Expenses  Break-even

• It presents the income and expenses for a given period.

• It can be presented according to function of expense/traditional

approach (e.g. cost of sales/services) or nature of
expense(itemized listing of expenses)
 Illustrative Income Statement
Mercado Consultancy Services
Income Statement
For the year ended December 31, 2017

Professional fees income PHP 5,500,000

Other income - training 60,000
Total Gross Income PHP 5,560,000

Less: Expenses
Salaries expense PHP 2,500,000
Rent expense 1,000,000
Utilities expense 500,000
Interest expense 120,000
Depreciation expense - office equipment 100,000
Depreciation expense - vehicle 90,000
Depreciation expense - office furniture 80,000
Communication expense 70,000
Insurance expense 60,000
Office supplies expense 50,000
Taxes & licenses expense 30,000
Dues & subscription expense 10,000 4,610,000
--> go to Statement
Net Income PHP 950,000 of Changes in Equity
 Statement of Changes in Equity

• It shows how the entity’s equity has changed during the period.

• For sole proprietorship, it is called “Statement of Changes in

Owner’s Equity”

• This statement shows the following:

– Beginning balance of owner’s equity
– Any additional investments made by the proprietor during the period
– Profit or loss during the period (net income/(net loss)
– Withdrawals by the owner during the period
– Ending balance of owner’s equity
Illustrative Statement of Changes in Equity

Mercado Consultancy Services

Statement of Changes in Equity
For the year ended December 31, 2017

Mercado Capital, January 1, 2017 PHP 3,000,000

Add: Net income during 2017 950,000
Total PHP 3,950,000

Less: Mercado Drawing 50,000

--> will go to equity
Mercado Capital, December 31, 2017 PHP 3,900,000 section of Balance Sheet
 Statement of Financial Position (formerly
Balance Sheet)

• Balance Sheet is a formal statement of the assets, liabilities and

owner’s equity of the business as of a given date

• It shows the financial position/standing of the Company as of a

given date

• It shows the detailed expression of the accounting equation,

Assets = Liabilities + Equity

• It can be in a report form (vertical presentation of assets, liabilities

and equity) or account form (horizontal presentation of assets,
liabilities and equity)
Illustrative Statement of Financial Position
Mercado Consultancy Services
Statement of Financial Position
For the year ended December 31, 2017

A S S E T S
Current Assets
Cash PHP 2,340,000
Accounts receivable 500,000
Office supplies 50,000
Prepaid insurance 180,000 PHP 3,070,000

Non-current Assets
Transportation vehicle, net of accumulated depreciation PHP 1,710,000
Office equipment, net of accumulated depreciation 400,000
Furniture & fixtures, net of accumulated depreciation 320,000 2,430,000
TOTAL ASSETS PHP 5,500,000

L IA BIL IT IE S
Current Liabilities
Accounts payable PHP 300,000
Notes payable 200,000
Accrued expenses 100,000 PHP 600,000

Noncurrent Liability
Loans Payable, 12% 1,000,000
TOTAL LIABILITIES PHP 1,600,000

O W N E R ' S E QU IT Y
Mercado Capital 3,900,000
TOTAL LIABILITIES AND OWNER'S EQUITY PHP 5,500,000
 Statement of Cash Flows

• It shows the sources and uses of cash

• Statement of Cash Flows can be presented through direct or

indirect method

• It provides information about the cash inflows (receipts) and

outflows (payments) of the business during a period. Cash
inflows or outflows can arise from:
– Operating activities: principal revenue-producing activities of the business
– Investing activities: acquisition and disposal of long-term assets and other
investments
– Financing activities: activities that result in the changes in the size and
composition of owner’s equity and long-term liabilities
Illustrative Statement of Cash Flows (Direct
Method)
Mercado Consultancy Services
Statement of Cash Flows
For the year ended December 31, 2017

Cash Flows from Operating Activities

Collections from customers on professional fees PHP 5,000,000
Collections from other income - training 60,000
Payment to employees for salaries (2,500,000)
Payment of rent (1,000,000)
Payment to suppliers
Payment of utilities (400,000)
Payment of insurance (240,000)
Payment of interest on loans payable (120,000)
Purchase of office supplies (100,000)
Payment for communication (70,000)
Payment for taxes & licenses (30,000)
Payment for dues & subscription (10,000)
Net cash provided from operating activities PHP 590,000

Cash Flows from Investing Activities

Cash paid for purchase of transportation vehicle (PHP 1,800,000)
Cash paid for purchase of office equipment (200,000)
Cash paid for purchase of furniture & fixtures (200,000)
Net cash used in investing activities (PHP 2,200,000)

Cash Flows from Financing Activities

Investment by the owner PHP 3,000,000
Personal drawing by the owner (50,000)
Proceeds from loans payable 1,000,000
Net cash provided from financing activities PHP 3,950,000
Net increase/(decrease) in cash PHP 2,340,000
Cash balance, January 1, 2017 -
Cash balance, December 31, 2017 PHP 2,340,000
 Basic Accounting
Concepts and Principles
 Business Entity Concept
• “The business is considered distinct and separate from the
owner(s) of the business.”

• The personal transactions of the owners are not included in the

records of the business. The business is considered as a
separate accounting entity/separate economic unit.

• Example: When Sam invests cash into the business, “SC

Consultancy Services”, the cash is no longer a personal resource
of Sam. It is already a resource/asset controlled by SC
Consultancy Services.
 Duality/Dual Effect of Transactions
• ASSETS = LIABILITIES + EQUITY (Accounting Equation)

• The effects of business transactions are recorded by entries to

two or more accounts and the total amount of the left side of the
accounting equation (i.e. Assets) is always equal to the total
amount of the right side of the equation (i.e. Liabilities and/or
Equity).

• For the accounting equation to be balance, any change in an

account must be matched with a corresponding change in another
account.
 Matching Principle/Matching of Costs
against Revenues

• It means that “income recorded and reported in one accounting

period should be matched against the expenses that directly or
indirectly contributed to the generation of income”

• Net income or net loss is computed by deducting the expenses

incurred from the income earned during the accounting period.
 Accrual Basis
• Under the accrual basis of accounting, income is recognized
when it is earned regardless of when cash is received. Expenses
are recognized when incurred, regardless of when cash is paid.

• Under the cash basis of accounting, income is recognized when

cash is received and expenses are recognized when cash is paid.

• Accrual basis of accounting is the generally accepted accounting

principle (GAAP). Cash basis of accounting is non-GAAP.
 Illustration 1: Income (Accrual Basis)
AJ opened a real estate consultancy firm on January 2, 2015. On
January 5, 2015, he received a call from a potential client asking for
his consultancy services. On January 10, 2015, he rendered the
necessary services based on their agreement. On January 15,
2015, he collected his professional fees amounting to P 20,000.

1. Using the accrual basis of accounting, when should AJ recognize

income?
Answer: January 10, 2015

2. Using cash basis of accounting, when should AJ recognize

income?

Answer: January 15, 2015

 Illustration 2: Expenses (Accrual Basis)
AJ opened a real estate consultancy firm on January 2, 2015. On
February 15, 2015, the business received a billing statement for
P7,000 from Meralco for the electricity charges for the month of
January 2015. The business paid the bill on February 20, 2015.

1. Using the accrual basis of accounting, when should AJ recognize

the electricity expense?
Answer: January 2015. Electricity expense should be accrued
at the end of January 2015.
2. Using cash basis of accounting, when should AJ recognize the
electricity expense?
Answer: February 20, 2015
 Periodicity (Time Period Concept)

• Under this concept, the operating life of an enterprise is

conveniently divided into time periods of equal length (e.g. 1 year)
called accounting periods.

• This allows accounting to provide information on a timely basis

and makes it possible for users of financial statements to assess
the condition and performance of the business across time
periods (e.g. comparing amount of net income this year from last
year)
 Going Concern Assumption

• Going concern means that the accounting entity is viewed as

continuing in operation indefinitely in the absence of evidence to
the contrary.
• The financial statements are normally prepared on the
assumption that an enterprise is a going concern and will continue
in operation for the foreseeable future.
• If the management becomes aware of situations giving rise to
uncertainties which may cast significant doubt as to the ability of
the enterprise to continue as a going concern entity, such
uncertainties should be disclosed in the financial statements
 Stable Monetary Unit

• The effects of the business transactions are normally recorded in

the accounting records in Philippine Peso as the monetary unit.

• Under this concept, accounting assumes that the Philippine Peso

is not materially affected by inflation. Peso values already
recorded in the financial records of an enterprise are not normally
revised to consider changes in the purchasing power of the peso.
 Definition and
Classification of Assets,
Liabilities, Equity,
Income and Expenses
 Basic Accounting Equation

ASSETS = LIABILITIES + EQUITY

Economic resources Financial Owner(s)

controlled by the obligations/debts of residual interest
business the business on the business
 Elements of the Financial Statements

• ASSETS: resources controlled by the entity as a result of past

events and from which future economic benefits are expected to
flow to the entity.

• Assets can be classified into:

– CURRENT ASSETS: assets which are expected to be realized, intended for
sale or consumption in the entity’s normal operations or held for trading
purposes within 12 months or less

– NONCURRENT ASSETS: all other assets not classified as current

 Elements of the Financial Statements

• LIABILITIES: present obligation of the entity arising from past

events, the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits

• Liabilities can be classified into:

– CURRENT LIABILITIES: obligations which are expected to be settled in the
entity’s normal operating cycle or within 12 months from the reporting date

– NONCURRENT LIABILITIES: liabilities which are not classified as current

 Elements of the Financial Statements

• EQUITY: residual interest in the net assets (assets less liabilities)

of the enterprise
 Elements of the Financial Statements

• INCOME: increases in economic benefits during the accounting

period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity.
Examples are revenues in the ordinary course of business and
gains (or other income not from the ordinary course of business)

• EXPENSES: decreases in economic benefits during the

accounting period in the form of outflows or depletion of assets or
incidences of liabilities that result in decreases in equity.
Examples are salaries, utilities, rent, used supplies, taxes
 Common Examples of
Account Titles Used for
Asset Accounts
 Account Titles Used for Assets

• Cash
• Held for trading securities
• Receivables
• Inventories
• Prepaid expenses
• Long-term investments
• Property, plant and equipment
• Intangible Assets
 Cash

• Medium of exchange for business transactions

• Recorded at face value
• Examples: currency and coins, checks, money orders, bank
drafts, demand deposit accounts
 Held for Trading Securities

• Temporary investments of excess cash which are primarily held

for short-term gain)
• Examples: investments in listed shares primarily held for trading
 Receivables

• Also known as collectibles. It represents claims against others

which arise in the ordinary course of business
• Examples are:
– Accounts receivables: claims against customers arising from the provision
of services or delivery of goods on credit
– Notes receivables: receivables in the ordinary course of business
evidenced by a promissory note from the customer
– Non-trade receivables: represent all other claims which are not in the
ordinary course of business (e.g. advances from employees)
 Inventories
• Held for sale in the ordinary course of business (e.g. finished
goods inventory for manufacturing company; merchandise
inventory for retail/merchandising business)

• In the process of production for such sale (e.g. work in process

inventory for manufacturing company)

• In the form of materials or supplies to be consumed in the

production process or rendering of services
 Prepaid Expenses
• Expenses paid for by the business in advance.

• They are assets when paid in advance. Subsequently, they

become an expense when used.

• Examples are: prepaid rent, prepaid insurance

 Long-term Investments
• Investment in assets for capital appreciation or capital distribution
(e.g. receipt of dividends)

• They are long-term if they are intended to be held for longer

periods (more than 1 year)
 Property, Plant and Equipment
• Tangible assets held by an enterprise for use in the production or
supply of goods or services, or for rental to others, or for
administrative purposes
• Except for land, all are subject to depreciation
• Expected to be used for more than 1 year.
• Examples are land, building, transportation and delivery vehicles,
furniture & fixtures, machinery and equipment
 Intangible Assets
• Assets which are identifiable, non-monetary, without physical
substance/existence.

• Examples are patents, copyrights, licenses, franchises and

trademarks
 Common Examples of
Account Titles Used for
Liability Accounts
 Account Titles Used for Liabilities
• Accounts payable
• Notes payable
• Accrued expenses
• Unearned revenues
• Mortgage payable
• Loans payable
 Accounts Payable
• Present obligations arising from the ordinary course of business

• Examples: purchase of goods or services from the supplier who

agrees to be paid in the near future (e.g. 30 days)
 Notes Payable
• Present obligations arising from the ordinary course of business
evidenced by a promissory note given to the supplier/creditors

• Promissory note is a written unconditional promise made by the

maker to the payee, engaging to pay on demand or at a fixed or
determinable future time a sum certain in money. It can be
interest-bearing or non-interest bearing.
 Accrued Expenses
• Business expenses already incurred but not yet paid.

• Examples: accrued utilities, accrued interest

 Unearned Revenues
• Cash (corresponding to the payment of the customer) is received
in advance but services are not yet rendered or goods are not yet
delivered. Income already received but not yet earned.

• This is a current liability because there is an obligation to provide

the services or deliver the goods.
 Mortgage Payable
• Long-term debts of the enterprise for which the company has
pledged certain assets as security/collateral for the debt.

• In the event that the debtor could not pay the obligation, the
creditor can “foreclose” or cause the mortgaged asset to be sold
and the proceeds are used to settle the debt.
 Loans Payable
• Can be short-term (less than 1 year) or long-term debts (more
than 1 year) of the enterprise obtained from financial institutions
(usually banks) for which there is a repayment of the principal and
interest at an agreed time interval.
 Common Examples of
Account Titles Used for
Equity
 Account Titles Used for Equity
• CAPITAL: account used to record the original and additional
investments of the owner of the business entity

• DRAWING: When the proprietor withdraws cash or other assets

for personal use.

• INCOME SUMMARY: Temporary account used to summarize all

income and expenses for a given period.
 Common Examples of
Account Titles Used for
Income
 Account Titles Used for Expenses
• Service Income/Professional Fees/Fees Income: Revenues
earned by performing services for customers

• SALES: Revenues earned as a result of sale of merchandise.

Applicable to merchandising and manufacturing business
 Common Examples of
Account Titles Used for
Expenses
 Account Titles Used for Expenses
• Cost of Sales: Cost incurred to purchase or produce the
products sold to customers during the period. For service
business, any expense which could be directly attributed to the
provision of services is called cost of services

• Salaries and Wages: includes all payments as a result of an

employer-employee relationship such as salaries or wages, 13th
month pay and other employee-related benefits

• Utilities expense (electricity, water, telephone): expenses

related to use of communication facilities and the consumption of
water and electricity
 Account Titles Used for Expenses
• Rent expense: Expense for leased office space, equipment or
other assets rented from others

• Supplies expense: The account used for recording the usage of

supplies in the normal course of business

• Insurance expense: Portion of premiums paid on insurance

coverage (e.g. vehicle, health, life, fire, typhoon or flood) which
has expired

• Dues & subscriptions expense: expenses related to

subscription to professional memberships, publications etc.
 Account Titles Used for Expenses
• Depreciation expense: Portion of the cost of a tangible asset
(e.g. buildings, equipment, vehicles) allocated or charged as
expense during the period.

• Bad debts/Doubtful accounts/Uncollectible accounts

expense: amount of receivables estimated to be uncollectible
and charged as expense during the accounting period.

• Interest expense: expense related for the use of borrowed funds

(e.g. interest on loans payable)

• Taxes and licenses: expenses related to municipal licenses,

business permits, professional licenses, local taxes
Normal Balances
 Normal Balances
• Assets – debit
• Liabilities – credit
• Capital – credit
• Drawings/Withdrawals - debit
• Income – credit
• Expenses - debit
End of Presentation