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GENERAL UNDERSTANDING ABOUT ACCOUNTING

Financial Statements

In layman’s language, financial statements are the accountant’s report at the end of the period intended for
the owner or business management’s use. These are the means by which the information accumulated and
processed in financial accounting are periodically communicated to various users which are the
management, prospective investors, creditors, labor unions, employees, government for income tax
purposes, public, etc.

For accountants, financial statements are structured financial representation of the financial policies of the
transactions undertaken by an enterprise and show the results of management’s stewardship of resources
invested to it.

Financial statements that are prepared monthly, quarterly, semi-annually or less than one-year period are
called interim financial statements.

Financial statements must possess the characteristics of understandability, which means that the language
used in financial reporting could easily be understood by the users. Remember, not all owners of business
are knowledgeable in accounting.

Financial statements must also possess the characteristics of timeliness. That reports should be submitted
on time in order not to defeat the purpose. What’s the use of the financial statements when submitted late?
The financial report must also be prepared in a neutral way. It must be fairly presented and free from bias.
It must be directed towards the interest of the users. It is not good to give favor to one party in detriment to
the others. This is neutrality in reporting the financial statements.

Per revised Philippine Accounting Standards (PAS) No. 1, there are six (6) basic financial statements but
we will focus our studies in four (4) statements which are as follows:

1. Statement of Financial Position (Balance Sheet)

2. Statement of Comprehensive Income (Income Statement)
3. Statement of Changes in Owner’s Equity
4. Statement of Cash Flows

Statement of Financial Position

Statement of financial position which is previously known as balance sheet is a financial statement that
shows the financial condition of the business as of a given date. It shows the Assets, Liabilities and
Owner’s Equity which are called “Accounting Values” or “Accounting Elements”. These are also
considered “Permanent Accounts” and are being outlined below as follows:

Assets- in layman’s language, these are the things of value or rights that are owned and used by the business
in the conduct of its operations such as cash, land, building, inventories, furniture and fixtures, machineries
and equipment, prepaid expenses, etc. It also includes accounts collectible by the business which we termed
as “receivable”. This tells us how much the business owns.

Liabilities- in layman’s language, these are debts or financial obligations of the business that are payable
in cash or in some kind of assets such as Accounts Payable, Notes Payable, Salaries Payable, Mortgage
Payable, etc. This tells us how much the business owes.

Owner’s Equity- in layman’s language, this refers to money or value of property put by the proprietor in
to the business to start with which refers to “initial investment”. Owner’s equity will be increased by profits
or additional investment and decreased by withdrawal, expenses and losses. Most often, owner’s equity is
the residual interest in assets after deducting all the liabilities. It is expressed in the equation as Assets less
Liabilities equals Owner’s Equity (A-L=OE). This tells us how much is left for the business.
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Statement of Comprehensive Income

Statement of comprehensive income which is previously known as income statement is a financial statement
that shows the “result of operations” of the business for a given period of time. The period covered by the
statement may be:

“For the month ended ___________________.”

“For the quarter ended __________________.”
“For the six months period ended ___________.”
“For year ended ______________.”

The information presented in the Statement of Comprehensive Income is usually considered the most
important information provided by financial accounting because profitability is the paramount concern to
those interested in the economic activities of the enterprise.

Revenues or Income- denote money or proceeds from services rendered by a service company or income
from use by other entities of the resources of the enterprise such as Rent Income, Royalties, etc. Service
companies like Auto Repair Shop, Laundry Shop, Barber Shop, Beauty Parlor, etc. and Professional Income
such as Auditing Fees, Legal Fee, Retainers Fees and others.

Expenses– denote the benefit received by the business from its use which had helped in carrying out its
operation, like salaries expense, rent expense, repairs and maintenance, taxes and licenses, etc.

Profit (loss)– the excess of revenues over expenses is called “profit”, while the excess of expenses over
revenues is “loss”.

Statement of Change in Owner’s Equity

A statement of changes in owner’s equity is a financial statement that summarizes the changes in equity for
a given period of time. The beginning equity of the owner is increased by the additional investment and
profit. Correspondingly, it is decreased by withdrawal and loss.

Statement of Cash Flows

A statement of cash flows is a financial statement that provides information about the causes of change in
the company’s cash balance from the beginning up to the end of specific period.

Like your Statement of Comprehensive Income, it is dated “for the period ended”. When we speak of
accounting periods, it can be at the end of a “month, quarter or annual”.

Basically, the Statement of Cash Flows is similar to the Statement of Cash Receipts and Disbursements.
Receipts are inflows or sources while disbursements are outflows or uses of cash.

Elements of Financial Statements and Account Titles Used

The five (5) types of major accounts are considered the elements that are directly related to measurement
of financial condition in the Statement of Financial Position are the Assets, Liabilities, and Owner’s
Equity, while the elements directly related to measurement of performance in the Statement of
Comprehensive Income are Income and Expenses. These accounting elements are given account name
or account titles.

Assets– these are defined as “resources controlled by the enterprise as a result of past transactions and
events and from which future economic benefits are expected to flow to the enterprise”. In layman’s term,
assets are defined as things of value that are owned and used by the enterprise in its operations. Examples
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are cash, building, land, machinery, furniture & fixtures, equipment, tools, etc. It also includes inventories,
prepaid expenses and a debt collectible by the enterprise from a customer which we termed as a receivable.

Per Philippine Accounting Standards (PAS No. 1), assets are classified into two, namely: current assets
and non-current assets.

Current Assets– refer to all assets that are expected to be realized, sold or consumed within the enterprise’s
normal operating cycle. Operating cycle is the interval of time from the date of acquisition of merchandise
inventory, sell the inventory to customers and the ultimate collection of cash from the sale.

Cash– the account title to describe money, either in paper or in coins and money substitutes like check,
postal money orders, bank drafts and treasury warrants. When cash is within the premise of the business,
the account title is Cash on Hand and Cash in Bank if deposited in the bank.

Cash Equivalents– PAS No. 7 defines cash equivalents as short term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an insignificant risk of change in
values because of change in interest rates.

Petty Cash Fund- an account title for money that is separately placed inside the box and set aside for petty
or small expenses. This usually happens when a company opens a bank account (savings or current) where
it requires a withdrawal slip or issuance of check every time it makes disbursements. It is time consuming
and it is not wise to make withdrawal slip or issue a check to pay a small amount of expenses of let’s say
P15.00 for jeepney fares. This fund is handled by a petty cashier who is accountable for its disbursements.
The petty cashier is warned not to mix his/her personal money with the petty cash fund.

Notes Receivable– this is a promissory note that is received by the business from the customer arising from
the rendering of services, sale of merchandise, etc. this can either be an interest bearing or non-interest
bearing.

Accounts Receivable- the account title for amounts collectible arising from services rendered to a customer
or client on credit or sale of goods to customer on accounts. This constitutes an oral or verbal promise to
pay by a customer or client.

Estimated Uncollectible Accounts– this is an asset-offset or a contra-asset account. It provides for possible
losses from uncollectible accounts. Although this is not actually an asset, it is classified as such because it
is shown as a deduction from the Accounts Receivable which is a current asset account. This is called
estimated uncollectible accounts or allowance for doubtful accounts which we previously termed as
allowance for bad debts.

Advances to Employees– the account title for amounts collectible from employees for allowing them to
make cash advances which are deductible against their salaries or wages.

Inventories– Per PAS No. 2, these are assets which are (1) held for sale in the ordinary course of business;
(2) in the process of production for such sale; or (3) in the form of materials or supplies to be consumed in
the production process or in the rendering of services.

Supplies Inventory or Unused Supplies– an account title for cost of stationery and other supplies
purchased for use but are left on hand and still unused. The account title should be specified as to Unused
Office Supplies if intended for the office, Unused Shop Supplies if intended for the shop, etc.

Prepaid Expenses- account title for expenses that are paid in advance but are not yet incurred or have not
yet expired such as Prepaid Rental, Prepaid Insurance, Prepaid Interest, Prepaid Advertising, etc.

Accrued Income– account title for income that is already earned but it has not yet been collected. In other
words, it has semblance of a “receivable” account.

These accounts are normally arranged according to liquidity (ready conversion to cash) in the Statement of
Financial Position.
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Non-Current Assets:

Property and equipment– the International Accounting Standards No. 16 define property and equipment
as tangible assets which are held by an enterprise for use in production or supply of goods and services, for
rental to others, or for administrative purposes, and which are expected to be used during more than one
period such as:

Land– an account title for the site where the building used as office or store is constructed. If land is
reserved for future use, it is classified as “investment property”.

Building– account title for a finished construction owned by the business where operations and transactions
took place.

Equipment– include calculators, typewriters, adding machines, computers, steel filling cabinets and the
like. If these are used in the office, the account title is Office Equipment and if used in the store, Store
Equipment. Trucks, jeeps, vans, automobiles and other kinds of motor vehicles are used exclusively for
delivering goods, the account title is Delivery Equipment.

Furniture & Fixtures– include chairs, tables, counters, display cases and the likes. If these are used in the
office, the account title is Office Furniture & Fixtures and if these are used in store, the account title is
Store Furniture & Fixtures.

Accumulated Depreciation– this is an asset-offset or contra-asset account. This is shown as a deduction

from property and equipment. Each property and equipment should be provided with their individual
valuation account.

The assets that are classified as Property & Equipment or Fixed Assets are called depreciable assets and
are subject to depreciation except “land”. Land is not subject to depreciation because it is expected to be
useful to the business enterprise for an indefinite period of time.

Liabilities– these are defined as “financial obligations of the business to its creditors. It represents the
claim of the creditors over the assets of the enterprise”. Per PAS No. 1, liabilities are classified only into
two, namely: current liabilities and non-current liabilities.

Current Liabilities– are financial obligations of the enterprise which are (a) expected to be settled in the
normal course of the operating cycle; (b) due to be settled within one year from the Statement of Financial
Position date.

Accounts Payable– an account title for a financial obligation of an enterprise that constitutes an oral or
verbal promise to pay.

Notes Payable (short-term)- same as Accounts Payable in nature but only the obligation is evidenced by
a promissory note. The enterprise is the one who issued the note.

Accrued Expenses– these are the expenses incurred by the enterprise but are not yet paid. This normally
occurs when the accounting period ended such as rent payable, salaries payable, interest payable, taxes
payable, etc. It has a semblance of a “payable” account.

Unearned Income– this is an account title for an income collected or received in advance but services have
not been rendered yet.

Non-current Liabilities:

Notes Payable (long-term)– same nature with that of Notes Payable (short-term) but only, this requires
payment for more than a year.

Mortgage Payable– a financial obligation of the enterprise which requires a fixed or tangible property to
be pledged as a collateral to ensure payment.
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Owner’s Equity or Capital– this is the “residual interest in the assets of the enterprise after deducting all
its liabilities”. It is expressed in the equation as Assets less Liabilities equals Owner’s Equity or Capital. It
is increased when there is profit of additional contributions by the owner and decreased when there is loss
or withdrawal by the owner. In layman’s language, Owner’s Equity or Capital is the amount of money or
value of property put by the proprietor into the business to start with the operation which is referred to as
Initial Investment or Initial Capital. Capital is synonymous to Proprietorship, Proprietary Interest or Net
Worth.

The owner’s capital be given a title by indicating the name, with the word Capital written after the name
which is separated by a “comma”.

Withdrawal– The owner’s withdrawal is likewise indicated by the use of the owner’s name with the word
Drawing or Personal written after the name which is separated by a comma.

Income & Expense Summary– this is a temporary account created at the end of the accounting period
where Income and Expenses are temporarily closed to this account.

Income or Revenue– these refers to the “proceeds from services rendered by a servicing firm, income
from use by other entities of the resources of the enterprise like royalty’s income, rent income, interest
income etc.”. It also includes proceeds from sale of merchandise.

Service Income– in general, this is the account title used for all types of income derived from rendering of
services. Sometimes the account title used is Service Revenue. Other specific income account titles used
are:

Professional Income– the account title generally used by professionals for income earned from the practice
for their profession or may be specified as Accounting or Auditing Fees Income for Accountants, Legal
Fees Income for Lawyers, Dental Fees Income for Dentists, Medical Fees Income for Doctors, etc.

Rental Income– for income earned on buildings, space or other properties owned and rented out by the
business as the main line of its activity.

Interest Income– for income received by the business arising from an amount of money borrowed by a
customer and usually covered by a promissory note. This is typical in lending institutions.

Miscellaneous Income– for income earned by the business which is not the main line of its activity and
could not be clearly classified.

Expenses– these are the “gross outflow of economic benefits during the period arising in the course of
ordinary activities of an enterprise when those outflow result in decrease in equity, other than those relating
to distribution to owners”.

Supplies Expense– this represents cost of supplies that were used and consumed that bears specific titles
as office supplies expense, store supplies expense, shop supplies expense, etc.

Rent Expense– for the amount paid or incurred for use of property, usually premises.

Repairs and Maintenance Expense– for expenses incurred in repairing or servicing the buildings,
machineries, vehicles, equipment, etc., which are owned by the business.

Salaries Expense– for compensation given to employees of a business. It may be specified as Office
Salaries, Salesmen’s Salaries, etc.

Uncollectible Accounts– for the anticipated loss that the business may incur arising from uncollectible
accounts.

Depreciation Expense– for the portion of the cost of property and equipment or fixed assets that has
expired based on rational and systematic allocation procedure.
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Taxes and Licenses– for the amount paid for business permits, licenses and other government dues except
the income tax paid which is not allowable by law as a deduction.

Insurance Expense– account title for the expired portion of the insurance premium paid.

Utilities Expense– the account title for telephone, light and water bills.

Interest Expense– an expense incurred from borrowed money. This is separately shown as a deduction
from profit before finance charges to arrive at profit.

Miscellaneous Expense– any amount paid as expense which is not significant enough to warrant a
particular classification.

Gas & Oil– the account title for gasoline, diesoline, lubricants, grease, fluids, lube oils, etc. for use by
company vehicles.

Forms of Business Organization and their Types of Activities

There are four (4) forms of business that persons may choose to organize depending upon their intention
and capacity to contribute funds for the business. They are as follows: Single or Sole Proprietorship,
Partnership, Corporation and Cooperatives.

Single or Sole Proprietorship

This is the simplest form of business organization where capital is owned and provided by one person called
proprietor, who may manage the business by himself or hire another person to do so.

Whatever happens to the business, whether it succeeds or fails, the owner has to bear it all including any
unpaid obligations that the business may have incurred. That is the reason why the business itself does not
file and pay income tax. The net income of the business is reported in the owner’s personal income tax
return.

As there is only one owner in the sole proprietorship business, the capital account is called “Owner’s
Equity”.

Partnership

This is formed by two (2) or more persons called “partners” who set forth agreements among themselves
on how profits and losses are divided. Two or more persons may form partnership for the exercise of
profession. A partner may contribute personal services to the partnership.

Since partnership is merely a contract, it can be terminated anytime. One cannot be admitted in the
partnership without the consent of other partners. As these are two or more partners, the capital account is
called “Partners Equity”.

Corporation

This is the biggest and most complicated form of business organization. This is organized by at least five
(5) but not more than fifteen natural persons called “incorporators” and the corporate charter which is
called “Article of Incorporation” is registered with the Securities and Exchange Commission (SEC) which
is filed together with its by-laws. In a corporation, capital is called “share capital” which is divided into
units called “par value”. There are two (2) classes of share capital; ordinary and preferred share. Owners
of the shares of stocks are called shareholders. Their ownership is evidenced by “share certificate”. Shares
of stocks can be transferred without dissolving the corporation so it enjoys unlimited life. Although the
maximum number of years that corporations to exist is 50 years, it can extend its life by amending the
Article of Incorporation. This is the reason why there are corporations that existed for more than 100 years.
As there are hundreds if not thousands of shareholders, the capital is called “Shareholder’s Equity”.
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Cooperative

This is formed by fifteen (15) or more natural persons who are Filipino citizen, of legal age, having a
common bond of interest and are actually residing or working in the intended area of operation. Actually,
it operates similar to a corporation. Their charter which is called “Articles of Cooperation” is registered
with Cooperative Development Authority (CDA). It has its Board of Directors who are elected among its
members. The General Assembly shall be the highest policy-making body of the cooperative. Their voting
share is on a one man, one vote.

The net surplus of the cooperative will be divided by among themselves after deducting the following
statutory requirements which are as follows: 10%- General Reserve Fund, 10%- Cooperative Education
and Training Fund, 7%- Optional Fund and 3%- Community Development Fund.

The balance of 70% is for interest on share capital and patronage refund which will be given during the
Annual General Assembly Meeting.

As there are hundreds or thousands of members in cooperative, the capital account is called “Member’s
Equity”.

Types of Activities

Service Concern- the business derived its income from services rendered to clients in case of professional
services, like that of accountants, lawyers, doctors, dentists, etc., or to customers in the case of non-
professional services, like that of a hotel where room rental is the main line of their business, laundry shop,
car repair services, janitorial services, internet café, etc.

Merchandising Concern- the business is engaged in buying goods or commodities or any form of finished
products and sells them at a profit. It might be at retail or whole sale basis. Grocery stores are best example
of this nature of business. It also includes food and beverage sold in restaurants and related establishments.

Manufacturing Concern- the business is engaged in buying of raw materials and supplies to be processed
or manufactured, converting them into finished products for sale at a profit, like that of a furniture shop,
manufacturers of cars and home appliances, etc. Bakeries and restaurants are no exceptions.

Hybrid Companies- are those involved in more than one type of activity which are manufacturing,
merchandising and service. The trend of our business establishments nowadays is more of hybrid companies
wherein you can hardly identify as to what activities they are engaged in. For example, a hotel operating
with a restaurant.

“NO PRESSURE, NO DIAMONDS.”

Prepared by:

JOHN JOSEPH R. PERMEJO, CPA

Part-time Lecturer
Eastern Visayas State University- Main Campus
johnjosephpermejo05@gmail.com