Chapter 1

Introduction to Accounting

Learning Objectives
1. Define accounting.
2. Describe the nature and purpose of accounting.
3. Give examples of branches of accounting.
4. State the function of accounting in a business.
5. Differentiate between external and internal users of

accounting information.
6. Narrate the history/origin of accounting.
7. State the forms of business organization.
8. State the types of business according to their activities.

Definition of accounting
Accounting is a process of identifying, recording and
communicating economic information that is useful in making
economic decisions.

Essential elements of the definition of accounting

1. Identifying The accountant analyzes each business
transaction and identifies whether the transaction is an "accountable event" or
"non-accountable event." This is because only "accountable events"
are recorded in the books. of accounts. "Non-accountable events" are not
recorded in the

books of accounts.

"Accountable events" (or 'economic events') are those that

affect the assets, liabilities, equity, income or expenses of a
business. Sociological and psychological matters are outside
the scope of accounting.

2. Recording
1

The accountant recognizes (i.e., records) the identified

"accountable events." This process is called "journalizing."

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After journalizing, the accountant then classifies the effects of the event on the "accounts." This
process is called "posting."

Account is the basic storage of information in accounting, e.g., "cash," "land," "sales," etc.

3. Communicating - At the end of each accounting period, the accountant summarizes the
information processed in the accounting system in order to produce meaningful reports. This is
important because information processed in the accounting system is useless unless it is communicated to
interested users. Accounting information is communicated to interested users through accounting reports,
the most common form of which is the financial statements.

Nature of accounting
Accounting is a process with the basic purpose of providing information about economic activities
that is intended to be useful in making economic decisions.

Types of information provided by accounting

1. Quantitative information - information expressed in numbers,
quantities, or units.
2. Qualitative information - information expressed in words or descriptive form. Qualitative
information is found in the notes to financial statements as well as on the face of the other components of
financial statements.
3. Financial information information expressed in money. Financial information is also
quantitative information because monetary amounts are normally expressed in numbers.

Accounting as science and art

1. As a social science, accounting is a body of knowledge which has
been systematically gathered, classified and organized. 2.As a practical art, accounting
requires the use of creative skills
and judgment.
Introduction to Accounting

Accounting as an information system

A system is one that consists of an input, a process, and an output For example, in your digestive
system, the input is the food you eat; the process is when your body produces digestive juices tc
convert the food into an output called?
.......energy! (The output my friend is energy. The one you are thinking of is called waste.) Your
body needs energy so it can function properly.
Similarly, in an accounting system, the inputs are the identified accountable events; the processes are
recording, classifying and summarizing; and the output is the accounting report that is
communicated to the users.

Bookkeeping and Accounting Although bookkeeping function is part

part of accounting, bookkeeping and accounting are not the same.
> Bookkeeping refers to the process of recording the accounts or transactions of an entity.
Bookkeeping normally ends with the preparation of the trial balance. Unlike accounting,
bookkeeping does not require the interpretation of the significance of the information processed..
Accounting, on the other hand, covers the whole process of identifying, recording, and
communicating information to interested users.

Functions of Accounting in Business

Accounting is often referred to as the "language of business" because it is fundamental to the
communication of financial. information.

Accounting has the following two broad functions in a

business:

1. To provide external users with information that is useful in

making, among others, investment and credit decisions; and 2. To provide internal users with
information that is useful in
managing the business.
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Users of Accounting information
Users of accounting information are broadly classified into two, namely:
1. Internal users - those who are directly involved in managing the
business. Examples of internal users include:
a. Business owners who are directly involved in managing
the business

b. Board of directors

c. Managerial personnel

2. External users those who are not directly involved in managing the business. Examples of external
users include: a. Existing and potential investors (e.g., stockholders who
are not directly involved in managing the business)
b. Lenders (e.g., banks) and Creditors (e.g., suppliers)
Government agencies (e.g., Bureau of Internal Revenue 'BIR', Securities and Exchange Commission
'SEC')
C.

d. Non-managerial employees
e. Customers
f. Public

Users of Accounting Information

Yes
Directly
 involved in managing the
business?

No
Types of accounting information classified as to users' needs 1. General purpose accounting
information is information designed to meet the common needs of most statement users. It is provided
by financial accounting and is prepared primarily for external users.

2. Special purpose accounting information. is information designed to meet the specific needs of
particular statement users. It is provided by management accounting or other branches of
accounting and is prepared primarily for internal
users.

Examples of decisions and types of information needed to make those decisions

User

1. External user (Investor)

2. External user (Lender or supplier)

Example of decision to make > Existing investor: Whether to hold
or sell

investment in

stocks.

Potential investor:

Whether or not to buy shares of stocks..

Lender: Whether or not to extend loan to a
business.

Supplier: Whether or not to extend

credit to a

business.
Example of information needed
Audited financial
 statements of the

business to aid in analyzing the value of the

company. (General purpose information)

Audited financial

statements of the

business to aid in analyzing the company's ability to pay its debts. (General
purpose information)

Internal user
External user

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3. Internal user

(Manager)
Whether or not

to increase the

sale price of a product.

➤ Analysis of the
effects of sales

volume and sales

prices to
earnings. (Special

4. Internal user

(Manager)
 >How much

capital is needed to
manufacture a new
product?
purpose information)

▷ Budget report.
(Special purpose information)

Examples in which accounting is used in investment and

credit decisions

External user of
information
1. Investor
Decision
Accounting
information
Shall I invest in
The financial

this business? Is
performance of the
business.
2. Creditor
this a profitable
undertaking?

Shall I lend money to this business? Does

this business have

the ability to pay back
my loan?
The ability of the business to
generate revenue
and cash flows

from its operations.

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related subjects.

8. Accounting
Research
•

> Accounting
research papers, articles and similar publications.

Forms of Business Organizations

students, business owners, accounting professionals in their Continuing Professional Development (CPD), and
other interested parties.

> Required by
business owners, professional organizations, and other
interested

parties.

A business is an activity where goods or services are exchanged for money. A person who is
engaged in business is called an entrepreneur or businessman.
Businesses in the Philippines are organized in one of the
following:

1. Sole or single proprietorship - is a business that is owned by only one individual. It is

the most common and simplest form of a business organization. The business owner is
called a "sole proprietor."
A sole proprietorship is registered with the Department of Trade and Industry (DTI).

2. Partnership
is a business that is owned by two or mor the individuals who entered into a
contract to carry on
3.
business and divide among themselves the earnings therefrom. The business owners are called partners.
A partnership is registered with the Securities and Exchange Commission (SEC).

Corporation - a corporation is also owned by more than one individual. However, unlike a partnership, a
corporation is created by operation of law rather than a contract. Ownership in a corporation is
represented by shares of stocks. The owners are called stockholders or shareholders.
A corporation is an artificial being or a juridical person, meaning in the eyes of the law, a
corporation is like a person, separate from its owners. Therefore, a corporation can transact on its
own, have its own properties, incur its own obligations, and sue or be sued.
For example, when you buy goods from a corporate business, you are actually transacting with the
corporation and not its owners. If you get sick from consuming the goods, you will sue the
corporation and not its owners.
A partnership also has a juridical personality. However, unlike for corporations, the partners are
viewed as agents of the partnership. Meaning, the partners transact on behalf of the partnership.
For example, if you transact with a partner of a business, you are transacting with the partnership
through the partner; while if you transact with a stockholder, this does not necessarily mean that
you are transacting with the corporation.
The incorporators (i.e., founders) of a corporation shall not be less than 5 but not more than 15 individuals.
However, a corporation can have as many stockholders as its authorized capitalization permits.
A corporation is registered with the Securities and Exchange Commission (SEC).

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-

4. Cooperative a cooperative is also owned by more than one individual.

However, a cooperative is formed in accordance with the provisions of The Philippine
Cooperative Code of 2008. The owners of a cooperative are called members.
From the root word "cooperate," a cooperative is an association of individuals who joined together to
contribute capital and cooperate in order to achieve certain goals.
For example, a group of farmers may form a cooperative to acquire delivery trucks to be used in
transporting their produce to the market. In here, the farmers voluntarily join together to achieve
a common goal, which is to address their need to get their produce to the market.
Another concept of a cooperative is that members need to patronize the cooperative's goods or
services. In the example above, the member farmers shall hire delivery trucks from the cooperative rather
than from other businesses. If the cooperative earns profit (net surplus), a farmer can recover his
costs through patronage refunds. Patronage refund pertains to the profit that a cooperative
returns to its owners. It should be noted that a member who has not patronized any of the services of
the cooperative for an unreasonable period of time may be removed from the cooperative upon the
majority vote of the board of directors.
A cooperative also has juridical personality similar to a corporation.
The founding members of a cooperative shall not be less than 15 individuals. However, a
cooperative can have as many members as its by-laws permit.
A cooperative is registered with the Cooperative Development Authority (CDA).
Introduction to Accounting

Summary: Forms of Business Organizations

Form of business organization

1. Sole proprietor

2. Partnership
Ownership

> One individual

(i.e., sole proprietor)

> More than one

(i.e., partners)
Formation/

Registration Registered with the DTI.

> Formed by
contractual

agreement. Registered with

the SEC.

3. Corporation
> More than one

(i.e., stockholders)
>
Formed by

4. Cooperative
More than one (i.e., members)
17
operation of law Registered with
the SEC.

> Formed in

accordance with the Cooperative Code.

Registered with the CDA.

Advantages and Disadvantages of the Different Forms of Business Organizations

Sole Proprietorship

Advantages
You are the boss and you keep all the profits.

Decision making is simple because you have complete control over the business.
Disadvantages
You assume all the risk of loss.

You take all responsibility and rely mostly on yourself in making decisions.

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18

Relatively easier and less costly to form because there are fewer formal business requirements.
Lower extent of

government regulation and

relatively lower taxes.

Partnership

Advantage
Better business decisions can be made because "two heads are better than one."

You share the business risk and the responsibility of running the business with your partner(s).

Compared to corporations and cooperatives, a partnership is easier to form because only a contractual
agreement between the partners is needed.

Greater capital compared to a sole proprietorship.

Relatively lower extent of government regulation compared to corporations.

Chapter 1

It is more difficult to raise capital because you rely mostly on your personal assets and loans to initially finance
the business.

You are personally liable for the debts and obligations of the business.

Disadvantage
Making business decisions may give rise to conflict among the partners.

You don't keep all the profits because you need to share them with your partner(s).

Limited life, in the sense that a partnership can be easily dissolved by the withdrawal, retirement, death or
insanity of one of the partners.

Lesser capital compared to a corporation.

A partnership (other than a general professional partnership) is taxed like a corporation.

Introduction to Accounting
Corporation

Advantage
A stockholder who is not a member of the corporation's board of directors is relieved from managerial responsibilities. Only
the stockholders that are elected as members of the board of directors and those they hire or appoint are tasked with
managerial responsibilities. This can be an advantage because a regular investor does not need to work for the
corporation to earn income.

Limited liability of the owners because stockholders are liable for corporate debts only up to the amount they have
invested.

Greater capital and ease in raising additional funds because a corporation can issue shares to a wider
extent of investors.
Unlimited liability. The partners can be held liable for partnership debts up to their personal assets.

Disadvantage Your "say" on corporate affairs depends on the number of shares you own. Those who own more
shares are the bosses and enjoy a larger share of the corporation's profits.,
19
A corporation is more difficult and more costly to form because there are more formal business requirements.

Greater extent of government regulation and higher taxes.

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If the corporation is listed,
you can easily transfer your shares to other investors by selling them in the stock market. Many
investors earn profit this way - by buying shares at a cheap price, wait for prices to go up, and then
sell them. This activity is referred to as stock trading.

Unlimited life, in the sense

that the withdrawal, retirement, death or
insanity of one of the stockholders does not dissolve the corporation.
Although a corporation has
a legal life of 50 years, this
can be renewed for an

indefinite number of

renewals.

Cooperative

Advantage
Unlike in a corporation, your "say" on cooperative affairs is not affected by the number of shares you own.
This is because, in a cooperative, each member
is entitled to only one vote
Unlike for a sole proprietorship or a partnership where business profits are easily distributed to the
owner(s), in a corporation, you have to wait for the board of
directors to declare dividends before you can get your share in the profits.

Disadvantage
A cooperative is prone to poor management. Cooperatives are, more often than not, managed by
members who were elected as board of directors rather than by employed
regardless of his or her shareholdings. However, members with larger shareholdings are entitled to larger
share in profit (net surplus).
A cooperative is generally exempt from paying taxes. This is the main advantage of a cooperative and
the most common reason why cooperatives are organized. Moreover, a cooperative may receive assistance from
the government.

Compared to a corporation, a cooperative is easier and less costly to form because there are fewer formal business
requirements.
professional managers.
Since there is a 'one- member, one-vote' policy in a cooperative, influential members tend to dominate the election process.
The result is that those who get elected may not be the ones who are most qualified for the task.

A cooperative is susceptible to corruption. Due to its management structure and lack of profit motive, the
elected officers may be inclined to act on their personal interests.

The Cooperative Code places some restrictions on the distribution of a cooperative's profit to its members. More
specifically, the Code requires a cooperative to appropriate a portion of its annual profit to some funds.
Only the remaining portion can be distributed to the members.

Furthermore, when the cooperative is dissolved,

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Limited liability - the

members are liable for cooperative debts only up to the amount they have invested.
the amount accumulated a fund called the "reserve fund" will not be returned to the members, but
rather donated to another cooperative or to the community.

Compared to a corporation, it is more difficult for a cooperative to sustain growth. This is in part because of
the lack of profit motive and the lack of management expertise. Moreover, a cooperative's success strongly
depends on the members' cooperation and members are not always willing to cooperate. The success of a
business depends on continuing effort. Sadly, many cooperatives are zealous at the start but fail to
sustain continuing effort resulting to the waning down of their activities. This does not mean though that all
cooperatives are small businesses. There are many multi-billionaire cooperatives in our country. Some
might be located in your community.
Unlimited life, in the sense that the withdrawal, retirement, death or insanity of one of the members does not dissolve the
cooperative.

Although a cooperative has a legal life of 50 years, this can be renewed for an indefinite number of renewals.
Unlike in a corporation where the stockholder can freely transfer his shares, in a cooperative, there are restrictions
on the transfer

of a member's shares. For example, the approval of the board of directors must
first be obtained before a

member can transfer his or

her shares.

Types of Business According to Activities

The following are the major types of business according to the activities they undertake:
1.
Service business

2. Merchandising (Trading)
3. Manufacturing

Service business

A service business is one that offers services as its main product rather than physical goods. A service
business may offer professional skills, expertise, advice, lending service, and similar
services.

Examples of service businesses include:

a. Schools

b. Professionals (accounting firm, law firm, electrician, etc.)

Hospitals and clinics
c.
d.
Banks and other financial institutions
e. Hotels and restaurants
.
1

f. Transportation and travel (taxi operator, travel agency, etc.)

g. Entertainment and event planners (wedding planners, concert
promoters, etc.)

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24
apter1

Merchandising business

A merchandising business (or trading business) is one that buys

and sells goods without changing their physical form. Examples of merchandising businesses
include:
a. General merchandise resellers (grocery stores, department stores, hardware stores,
pharmacies, online stores, sari-sari - stores, etc.)
b. Distributors and dealers (rice wholesalers, vegetable dealers,
2nd-hand cars dealers, etc.)

'Manufacturing business
A manufacturing business is one that buys raw materials and processes them into final products.
Unlike a merchandising business, a manufacturing business changes the physical form of the goods it
has purchased in a production process.
For example, a business that buys and sells eggs is a merchandising business. On the other
hand, a business that buys eggs and uses the eggs as ingredient in making cakes for sale is a
manufacturing business.

Examples of manufacturing businesses include:

a. Car manufacturers (Toyota, Isuzu, Volkswagen, etc.).
b. Technology companies (Apple, Samsung, Sony, etc.)
c. Food processing companies (San Miguel Pure Foods, Silver
Swan, etc.)
d. Factories (clothing factories, animal feeds factories, plastic
wares factories, etc.)

Some businesses, called hybrid businesses, engage in more than one type of activity. For example,
a restaurant uses ingredients to cook a meal (manufacturing), sells Coca-Cola drinks
(merchandising), and serves food to customers (service). Nevertheless, a hybrid business is classified
into one of the major types based on the activity that is most in line with the business' purpose.
Restaurants are expected to fill-in customer orders and provide dining services, thus, they are
more of a service-type business.
Introduction to Accounting
25

Advantages and Disadvantages of the Different Types of Business

Service Business

Advantages
You don't need to worry about inventory, warehousing and distribution costs because you don't have any inventory.
You only have some minimal supplies necessary in providing your services.
Disadvantages
You may not have a flexible personal time because you need to be directly involved in providing a service to a
customer. You can stock inventory but not service.

For example, if you are a manufacturer, you can spend over time to produce goods, stock them, and then take a
break. However, if you are a doctor, you are on call, and have to be the one to personally examine a patient.

Until your business is big enough to be able to hire other professionals to do the work for you, you will
need to render the services yourself...

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26
Chapte

You may only need a small capital because what you are selling is your skill set and you only need
yourself to render a service. If you are a manufacturer, you need to buy raw materials and machinery to
produce your product.
You are perceived as an expert in your chosen field. People respect you. You can also have fans!
Service businesses normall suffer first from decline in demand during times of economic
difficulty. This is because most services are perceived as luxuries rathe than necessities for survival.

For example, a guy with low funds would refrain from having a haircut and uses his funds for food instead.
A smart gal with low funds would cut back her expenditures on spa and pedicure.

Your business' success depends on your credibility. Personally, you must have a good reputation. You need to be
always discreet in the things you say and the way you act in the society.

Since a service business is founded on good reputation, it is more costly to commit an error in a
service business compared
to a merchandising

business. For example, if a merchandising business erroneously sells

damaged
Introduction to Accounting

Merchandising Business

Advantages Compared to a manufacturing firm, you may need a much lower start-up capital because you don't
need to acquire machineries to produce your goods.

You can take advantage of price fluctuations. For example, when goods are on sale, you can acquire them at a
discounted price and resell them at a much higher price. You can't do this in a service business.
goods, the customer can just return the goods and have them replaced. However, if you are a
barber and commits an

error, you can't just replace your customer's hair!

Disadvantages
You need to have a retail store to display your goods and the store must be in a strategic location for it to attract more
customers.
27

Less flexibility in managing costs. This is because the cost of your goods is based primarily on their purchase
price, which you do not control.

*In a manufacturing business, you can cut down costs by redesigning your product, improving your
processes, acquiring more efficient machines, employing more skillful personnel, and so much
more.

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Introduction to Accounting
29
Lower cost of quality. This
is because "what you buy is what you sell."

In a service or manufacturing business, you need to continually improve your products to maintain their
salability. In a merchandising business, if a certain product is not selling well, you can just stop
buying it and find an alternative product, another brand maybe.

It is much easier to start a merchandising

business because you don't need to have an expertise or a
special skill (service business) and you don't need to have invented a new product or have conceptualized an
innovative idea for an

existing product
(manufacturing business).

Keeping track of inventory is tedious, most especially when you are selling
numerous and varied items with fast turnover rate, like for example if your business is a
hardware store or a grocery store. Also, you can incur additional costs due to spoilages, theft,
breakages, damages, and obsolescence.

Self-satisfaction is low because you did not produce the products you sold.
Manufacturing Business

Advantages
You have a high growth potential because you can tap into a wider market and can produce in large
quantities.

You have the opportunity to establish a brand that could last longer than your lifetime. This is the ultimate
dream of most

entrepreneurs.

Self-satisfaction is high. Knowing that consumers are happy and satisfied with a tangible product you have
produced brings you pride and joy.

You may not need to have a strategically located retail store to display your products because you can sell
directly to wholesalers
. rather than to end

consumers.

Disadvantages You need a high start-up capital to acquire machineries, to employ people, and to acquire a
big space for your production.

Conceptualizing a viable manufacturing business is difficult. This is why more entrepreneurs would rather
engage in merchandising.

You need to be continuously innovative and abreast of changes in technology. If another company comes up with a
better and cheaper product, your product will automatically lose demand.

Warehousing and logistics costs can be high.

policy because mass production can decrease

You can have a better pricing
You rely on raw materials. You need to manage them properly to ensure that they

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your
unit cost (often called
'economies of scale').

For example, you are paying

rent of P100,000 for your
factory space. If you produce
only 1 unit of a product, your
unit cost is high because the
rent will be allocated to only
1 unit, i.e., P100,000 unit cost
(P100,000+ 1 unit). Therefore,
you need to sell this unit for more
 than P100,000 to earn profit.
However, if you produce
10,000 units, your unit cost
would be much lower

because the rent will be

allocated to more units, i.e., P10

(P100,000 ÷ 10,000 units).
You can now sell each unit at a
much lower price.

Greater flexibility in
managing costs. (See
discussion in disadvantage of a
merchandising business
above*)
are available when they are needed. This is because a shortage in a raw
material can disrupt your
operation, and that can be
very costly.

For example, when cooking

rice, all the ingredients you need
must be available. You cannot cook
the rice now and just add the
water later
on.

In a merchandising business,
if you run out of a specific
 good, you don't necessarily
need to close your store
because you can still sell
other goods.

Managing a manufacturing
business can be difficult because
production
processes are often
complicated and there is
always some room for
improvement (although
many skilled managers may take this positively as a challenge).

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