CHAPTER I

PURPOSE AND NATURE OF ACCOUNTING

Learning Outcomes

At the end of the chapter, learners shall be able to:

 define accounting and describe its nature, branches and fields;

 explain the functions of accounting in business;
 identify and distinguish the different branches and fields of accounting;
 identify the users of financial information; and
 explain the basic accounting concepts and principles

“Most of the important things in the world have been accomplished by people
who have kept on trying when there seemed to be no hope at all” - Dale Carnegie

Business and Accounting

Business is an undertaking where one seeks to make profit by selling goods or

rendering services. Some enterprises, however, are organized as non-profit
organizations to provide certain benefits to society. In any type of business or
organization, a lot of transactions and events happen every day. These transactions
should be recorded to have a ready reference for future operations.

Keeping records is an important aspect of a business. Without an effective

recording or accounting system and procedures, one would find it difficult to determine
how the business is fairing, whether it is earning profits or incurring losses.

Through accounting, quantitative information can be identified, measured and

summarized into financial reports that are to be communicated to the interested
parties. These financial reports provide information about the financial condition and
results of business operations which are bases for decision-making.

Types of Business Based on the Nature of Operations

A business organization can be classified based on the nature of business

operation. The purpose for which the business has been established will determine the
nature of activities. The following are the classifications:

1. Service business is one which is engaged in the rendering of services to

others for a fee. Examples are law firms, accounting firms, auditing firms,
 medical clinics, barber shops, beauty parlors, stock brokerage firms,
recruitment agencies, and the like.

2. Trading business is engaged in the buying and selling of goods or

commodities produced by other businesses which are called merchandise;
hence, it is also called a merchandising business. It is a link in the physical
distribution chain acting as a wholesaler or a retailer firm. Examples are car
dealers, grocery stores, supermarkets, cell phone and accessory traders and
gift shops.

3. Manufacturing business is engaged in the buying of raw materials,

converting them into finished products and selling to traders or final
consumers. Examples are car manufacturers, food processors, soft drink
bottling companies, drug manufacturers and paper mills.

The main difference between a trading and a manufacturing business is

that, a trading business buys goods and sells these goods in the same form
while a manufacturing business buys raw materials and sells goods that were
produced or processed out of the raw materials.

4. Hybrid business is one which is involved in more than one type of business
activities (service, merchandising and manufacturing).

Forms of Business Organization

A business operates in a complex environment that affects decision-making.

Two of the most important factors making up the firm’s operating environment are the
legal form of business organization and taxes. The accounting procedures depend on
which form the organization takes. The forms of business organizations are:

1. Single or Sole Proprietorship. This business organization is owned by an

individual who has complete control over business decisions. The owner is
called proprietor, who generally is also the manager. The owner is entitled
to all the profits, but absorbs all losses. He owns all the firm’s assets and is
responsible for all the debts of the business.

From a legal point of view, the proprietor is not separable from the
business and is personally liable for all debts of the business. However, from
an accounting perspective, the business has a separate and distinct
personality from that of the owner.

The owner is not paid salaries nor wages from the business. Instead, he
can withdraw funds or properties from the firm.

2. Partnership. This is a business owned and operated by two (2) or more

persons known as partners, who bind themselves to contribute money,

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property or industry to a common fund, with the intention of dividing the
profits between or among themselves.

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 The Articles of Co-Partnership which is to be filed at the Securities and
Exchange Commission (SEC) is a written agreement between or among the
partners, governing the formation, operation and dissolution of the
partnership.

3. Corporation. As defined in the Revised Corporation Code of the Philippines

(RA 11232), it is “an artificial being created by operation of law, having the
rights of succession and the powers, attributes and properties expressly
authorized by law or incident to its existence.”
The incorporation process is initiated by the filing of the Articles of
Incorporation with the SEC.

The owners are called shareholders or stockholders. These owners are

not directly involved in the management of the firm, instead, they select
managers designated as the Board of Directors to run the firm for them.

4. Cooperatives. A cooperative is a duly registered association of persons with

a common bond of interest, voluntarily joining together to achieve their
social, economic and cultural needs.

• The owners are called members who contribute equitably to the capital of
the cooperative.

• The members are expected to patronize their products and services.

• The word ‘cooperative’ appears in the name of the entity.

• This form of business organization is regulated by the Cooperative

Development Authority (CDA).

Micro, Small and Medium Enterprises (MSMEs)

In 2008, the Magna Carta for Micro, Small and Medium Enterprises, otherwise
known as Republic Act 9501, was signed into law. This law seeks to address problems
faced by MSMEs particularly the lack of capital and access to credit. It also updated the
definition of MSMEs as follows:

Assets before financing No. of Employees

Micro Enterprise P3 Million and below 9 and below
Small Enterprise More than P3 Million to P15 Million 10 to 99
Medium Enterprise More than P15 Million to P100 Million 100 to 199

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 These MSMEs are registered as any of the legal forms and nature of business.
Enterprises with assets and employees above the MSME threshold are considered large
enterprises.

Definition of Accounting

Accounting is the process of IDENTIFYING, RECORDING, and COMMUNICATING

economic events of an organization to interested users.” (Weygandt, J. et. al)

Important Activities in the Accounting Process

IDENTIFYING – this involves selecting economic events that are relevant to a

particular business transaction

The economic events of an organization are referred to as transactions.

Examples of economic events or transactions.

In a bakery business:
• sales of bread and other bakery products
• purchases of flour that will be used for baking
• purchases of trucks needed to deliver the products

Events are accountable when they affect the assets, liabilities and equity of
the business. There are business activities and events which are not
accountable because they cannot be quantified, or expressed in terms of a
unit of measure, like hiring of employees and entering into a contract.

RECORDING – this involves keeping a chronological diary of events that are

measured in pesos. The diary referred to in the definition are the journals
and ledgers which will be discussed in future chapters.

COMMUNICATING – occurs through the preparation and distribution of

financial and other accounting reports

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Accounting as the Language of Business

Accounting is considered as the language of business, as it is the medium of

communication between the business and the parties interested with the financial
activities of the business. Through accounting, business transactions are identified,
measured and summarized into accounting reports like financial statements. These
financial statements provide information about the financial condition and results of
operations of the business, which owners, creditors, employees, and government
agencies may use to make informed business decisions.

Accounting and Bookkeeping

Whatever the type of business activity, all enterprises need common basic
information about financial operations. The function of providing information and
establishing financial records for planning and management of business affairs is what
accounting and bookkeeping is all about.

Bookkeeping is a procedural element of accounting. It is the process of

recording financial transactions and keeping financial records. It is the information
processing function of accounting where business data are collected and summarized
into financial reports. Accounting, on the other hand, includes many complex activities
such as bookkeeping, the design of an information system that meets the user’s needs,
the analysis and interpretation of financial statements, preparation of tax and financial
reports, budgeting, auditing, planning and forecasting.

Accounting cannot exist independently of bookkeeping. An accountant must

know the principles and mechanics of bookkeeping. Hence, those who study accounting
are taught first the fundamentals of bookkeeping.

Today, computers are used for routine bookkeeping operations that used to
take weeks or months to complete manually. Basic accounting knowledge however, is
needed even though computers can do the routine tasks.

Fields of Accounting

The professional accountant may pursue a career in any of the following areas
of accounting practice: (1) Public Accounting, (2) Commerce and Industry, (3)
Government Accounting, and (4) Accounting Education.

Specialized Accounting Services

Financial Accounting is focused on the recording of business transactions and

the periodic reports on financial position and results of operations.

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 Auditing is the examination of financial statements by an independent auditor in
order to express an opinion on the fairness of the presentation of the financial position,
results of operation, and cash flows in conformity with generally accepted accounting
principles.
Government Accounting is concerned with the identification of sources and
uses of resources consistent with the provisions of city, municipal, provincial or national
laws.

Management Services is the processing of historical as well as projected data of

an entity to assist management in establishing plans for reasonable economic
objectives.

Tax Accounting encompasses the preparation of tax returns and consideration

of tax consequences of proposed business transactions.

Financial Management is concerned with the setting of financial objectives,

making plans based on those objectives, obtaining the funds needed to achieve the
plans, and generally safeguarding all the financial resources of the entity.

Management Accounting incorporates cost accounting data and adopts them

for specific decisions which management may be called upon to make. A management
accounting system incorporates all types of financial and non-financial information from
a wide range of resources.

Users of Financial Information

Financial information is used by different groups for a variety of purpose and

reason. These users may be internal or external decision makers.

Internal decision makers are the owner(s)/managers responsible for managing

the resources of the firm. They have the power and authority to obtain whatever
economic information they need in evaluating the efficiency on the use of resources.
They are also interested on the result of operations and financial condition as bases in
the formulation of plans and policies.

External decision makers include those parties interested with the financial
information of a business but lack direct access to the information generated by the
internal operations. This includes the following:

Investors are concerned with the risk inherent in and the return
provided by their investments. They need information to help them determine
whether to invest, buy, hold or sell shares.

Employees are interested in information about the stability and

profitability of their employers. They need information which enables them to
assess the ability of the enterprise to provide them fair remuneration,
retirement benefits and other employment opportunities.

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 Creditors and suppliers are also interested in the financial information
for them to determine whether credit should be extended or not.
Customers have interests in information about the continuance of
business operations, especially when they have long term involvement with the
firm or are dependent on the enterprise.

Government and their agencies require information in order to regulate

the activities of enterprises, determine taxation policies and as basis for national
income and similar statistics.

The Public need information about the trends and recent developments
in the prosperity of the enterprise and the range of its activities.

Business Entity Concept

The most basic concept in accounting is the entity concept. An accounting entity
is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. Transactions of different
entities should be accounted for separately. In like manner, the personality of the
owner or owners of a business is separate and distinct from that of the business, thus,
transactions of the business should not be combined with the owner’s personal
transactions.

Basic Financial Statements

A. THE STATEMENT OF COMPREHENSIVE INCOME

It is a statement showing the performance of the business for a given period of

time. It summarizes the revenues earned and expenses incurred for that period and
communicates to the users its profitability status for a one-year operation.

B. THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)

It is a statement that measures the financial position of the business in terms of

Assets, Liabilities and Owner’s Equity. It shows the resources (Assets) employed by the
business first, followed by the claim of the creditors (Liabilities) against the assets, and
then the claim of the owner called Capital.

D. THE STATEMENT OF CASH FLOWS

The statement of cash flows provides information about the cash receipts and
cash payments of an entity during a period. It is a formal statement that classifies cash
receipts (inflows) and cash payments (outflows) into operating, investing and financing
activities.