CHAPTER 2

BASIC ACCOUNTING CONCEPTS

The accounting principles and processes, standards of recognition,
measurement, methods, and basic assumptions that are used in the preparation
and presentation of the primary financial statements– Balance Sheet and
Income Statement– are called Generally Accepted Accounting Principles. These
accounting principles are accepted, supported and understood by the members
of the accounting profession. Although called principles, these are not rigid or
fixed, but are continually evolving in response to the changes in the business
environment.
The specific information needs of the different data- users vary.
The accounting system of a business enterprise must be able to
provide for the general information needs of the varied data- users
through the general- purpose accounting reports. These general-
purpose reports must be prepared in accordance with certain
generally accepted “ground rules” and assumptions so that the
different users will be able to interpret their contents properly.
Assume that a piece of land with an assigned value of Php 200,000 is included
in the financial report of a business enterprise. Some questions that need
answers are:
1. What does this reported amount Php 200,000 represent?
2. Is it the land’s original cost to the business enterprise, is it the current
market value of the land, or is this amount its assessed value for purposes of
levying property taxes?
3. Who owns the land? Is the land fully paid for?
4. Furthermore, are there other claims on this property?
Obviously, the users of the financial reports must possess a sound
understanding of the standards and assumptions that are applied in
the preparation of such reports. In turn, the standards and
assumptions employed in the financial report preparation must
relate to the information needs of the users.
BASIC ACCOUNTING CONCEPTS
 ACCRUAL BASIS ACCOUNTING

Under this basis, the amount of net profit or loss is determined by deducting the
total expenses incurred during the period from the total income earned for the
same time frame. We have to understand that the term total expenses is not
synonymous to total cash payments, and that the term total income is different
from total cash receipts. Deducting the total cash payments from the total cash
receipts would give the balance of cash but not the amount of net profit or loss
of the period.
At the end of the reporting period, it may be possible that certain expenses have
already been incurred since their benefits have already been received even
though these expenses have not been paid for, or vice versa.
On the other hand, it is possible that there are certain income items that have
been earned but not yet collected from the customers, even though goods or
services have already been delivered. It is also true that there may be certain
income items that have been collected from the customer yet the corresponding
goods or services have not been delivered to them.
As stated earlier, the profit or loss under the accrual basis
accounting is computed by deducting the total incurred expenses
(whether the expenses are already paid for or not) from the total
earned income (whether the income is already collected or not).
 GOING CONCERN ASSUMPTIONS

Under the going concern assumption, also known as the community

assumption, the primary financial statements of a business enterprise are
prepared on the assumption that the normal operations of the enterprise will
continue indefinitely. The accounting elements and the corresponding amounts
reported in the Balance Sheet and Income Statement are determined based on
the assumption that the enterprise has no known intention of curtailing its
normal operations.
Unless otherwise disclosed, the assumption is that the business
enterprise is a going concern. However, if management is aware
of important uncertainties that may cast significant doubt on the
enterprise’s ability to continue as a going concern, that fact should
be specifically reported as part of the financial statements. If the
enterprise is no longer considered a going concern, the basis on
which the financial statements are prepared should also be
reported.
OTHER CONCEPTS
 BUSINESS ENTITY PRINCIPLE
This concept assumes that the business and its owner are separate
and distinct entities. As such, there should be separate accounting
and reporting of the transactions, resources, obligations, income,
and expenses of the business and those of the owner. Because of
the assumptions, better monitoring and reporting of the activities,
profitability, and financial condition of the business enterprise
would result.
 PERIODICITY CONCEPT
The assumption that the operating life of the business may be divided into time-
period is known as the periodicity concept or time- period concept. Because
timely financial information is needed to become the basis for decisions and
actions of the decision- makers, financial statements should be prepared
periodically, at least yearly. The need for periodic reports calls for the need to
divide the life of the business into reporting periods. The use of equal time-
periods for reporting purposes is helpful so that the reported information would
have the qualities of timeliness and comparability.
 CONCEPT OF EQUALITY OF THE VALUE
RECEIVED AND VALUE GIVEN UP

The recording and reporting of the business transactions are based

on the assumption that for every value received, there is an equal
value given up.
 MONETARY CONCEPT

It is assumed that the business that the business transactions

(activities and events) can be objectively measured or quantified
in terms of “peso”. Because of this concept, the transactions
recorded in the books of account and the elements reported in the
financial statements are expressed in terms of a common unit of
measurement, the peso. The use of this concept allows for a more
systematic aggregation and analysis of the reported data.
 MATCHING CONCEPT
Under this concept, it is assumed that the results of business
operations could be measured if there is proper matching of
income and expenses within a reporting period. Under this
concept, there should be a simultaneous recognition of income and
the corresponding expenses that are directly or indirectly
contributory to the earning of such income. It is the accrual basis
accounting, as discussed earlier, that results in a better matching of
income and expenses.
QUALITATIVE CHARACTERISTICS
OF FINANCIAL INFORMATION
As stated earlier, the objectives of accounting is to come up with financial
reports that will provide the data- users with necessary information for making
decisions. The four important qualities or characteristics that make financial
information useful in the decision- making process are:
1. Understandability
2. Relevance
3. Reliability
4. Comparability
 UNDERSTANDABILITY

One of the essential qualities of useful information is that it should be readily

understood by the data- users. Information that is comprehend only by a few
could even mislead the data- users. Presented data should be arranged and
formatted in a manner that adds to the usefulness of the financial reports as a
tool for decision- making. The use of generally accepted accounting
terminologies would also be helpful in attaining the quality of
understandability. On the other hand, using the vague captions and account
titles diminishes the benefits derived from the financial reports. Information
that is not understandable is irrelevant.
 RELEVANCE
Financial information possesses the quality of relevance when its
knowledge can make a difference in whatever decisions the data-
users will make. This is considered relevant if it has feedback
value and/or predictive value. Feedback value exists if the
reported information could be used to assess the outcome of past
activities and transactions. Predictive value of the reported
financial information exists if this could be used as a basis for
forecasting what may happen in the future.
Timeliness is another ingredient of relevance. Financial
information must be available on time so that it will be relevant.
Also, it must be ready before it loses its ability to influence the
decision- makers. Even accurate data can sometimes be useless if
they reach the decision- makers late.
 RELIABILITY

Financial information is considered reliable if it is verifiable, neutral, and if it

represents that which it is intendeds to represent (representational faithfulness).
Verifiability is said to exist if, assuming there are several independent
accountants who will repeat a method, they will obtain basically the same
results. On the other hand, neutrality exists when the recognition and
measurement of the reported financial information are not intended to favor
only a certain chose group of decision- makers or data- users.
Financial information is a faithful representation of the situation if
it is not biased. Bias exists if the accountant did not use the
measurement method properly or if the reported information is
consistently too high or too low in order to intentionally favor
certain interest groups.
 COMPARABILITY
To be useful to the decision- makers, the reported financial information should
be comparable. The quality of comparability allows the data- users to assess the
similarities and differences either for the same enterprise over different time
periods or among different enterprises for the same period of time. Consistency
in the application of the accounting methods will contribute to the
comparability of the financial information. To be consistent is to use the same
procedures, systems, and methods from one period to another. However, a
change to a more preferred method is allowed if the result of the change is
disclosed in the financial statements.
 PRUDENCE
An accountant is frequently confronted with situations where he is uncertain as
to what course of action to take. Even experienced accountants reach these
crossroads– situations wherein two or more equally acceptable alternative
methods could be suitably applied. In these instances, an accountant exercises
prudence by choosing to apply the method that will tend to make profit smaller,
thus, the method that has a less favorable effect on the balance of the owner’s
equity.
 MATERIALITY
An item of information is deemed material if it is important enough to have an
effect on the data- user’s decision- making process. Material information should
be reported on the face of the financial statements, or among the supplementary
notes that are attached to the financial statements. On the other hand,
immaterial items are those considered to be of little or no consequence and are
handled in the most practical and convenient manner without regard to the other
theoretical accounting principles.
 COSTS VS. BENEFITS
Financial information provides the data- users with certain benefits in their
decision- making process. However, gathering and monitoring financial
information entail expenses in the form of supplies, salaries, computers,
utilities, and others. In other words, the costs of gathering and providing the
information should be compared and associated with the benefits to derived
from it. The general rule is that financial information should be gathered or
provided to the data- users only if the benefits to be derived from it exceed the
costs of collecting and providing such information.