FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 1

Types of Business According to Activities, Accounting Concepts and Principles

OBJECTIVES
At the end of the session, the learners are expected to
1. compare and contrast the types of business according to activities;
2. identify the advantages, disadvantages and business requirement of each type;
3. explain the varied accounting concepts and principles; and
4. solve exercises on accounting principles as applied in various cases.

1. TYPES OF BUSINESS ACTIVITIES (objectives 1-2)

Business establishments may also be classified according to the type of business activity in which they are engaged. The
three broad classifications are
1) Service
2) Merchandising or Trading
3) Manufacturing

While a single company can be involved in all three of these business activities usually one of the three constitutes the
company's major interest. Some businesses provide a service while other businesses sell a product.
 A business that provides a service is called a service business.
 A business that purchases a product from another business to sell to customers is called a merchandising or
trading business.
 A business may make the product that it sells, or it may sell or product that another business made. A business
that makes a product to sell is called a manufacturing business.

Service business
These are companies that do not deal with tangible products but rather provides some sort of service as its major
operation. Doctors, CPAs, lawyers and engineers are examples of people who provide services instead of goods or
merchandise.

Merchandising business
Merchandising companies are involved in selling of finished goods produced by other businesses. This tangible, physical
product is called merchandise, hence the designation for this type of company. Merchandisers could either be a
wholesaler or retailer.

Wholesale merchandiser is a company that buys its product from the manufacturer (or another wholesaler),and then
sells the product to the company that eventually sells it to the consumer. Examples of wholesale merchandisers are
Columbia Wholesale School Supplies, Estela
Wholesale RTW.

Retail merchandiser is a company that buys its products from a wholesaler or manufacturer and then sells the product to
the end consumers. Examples of retailers are Shoemart, Rustan's Department Store, and Gift Shops. Clothing stores and
shoe stores are often individually owned retail operations.

Manufacturing business
Manufacturing is a type of business that changes basic inputs into products that are sold to individual customers.
Manufacturing companies are involved in the conversion of raw materials into some tangible, physical product.
Examples of well-known manufacturing companies are San Miguel Corporation, lntel (producer of computer
components), Purefoods Inc.

Hybrid Companies are those involved in more than one type of activity (manufacturing, merchandising, service).
FUNDAMENTAL CONCEPTS (objective 2.1)

Several fundamental concepts underlie the accounting process. In recording business transactions, accountants should
consider the following:

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.
Simply put, the transactions of different entities should not be accounted for together. Each entity should be evaluated
separately.

Periodicity Concept. An entity’s life can be meaningfully subdivided into equal time periods for reporting purposes. it
will he aimless to wait for the actual last day of operations to perfectly measure the entity's net income. This concept
allows the users to obtain timely information to serve as a basis on making decisions about future activities. For the
purpose of reporting to outsiders, one year is the usual accounting period.

Stable Monetary Unit Concept. The Philippine peso is a reasonable unit of measure and that its purchasing power is
relatively stable. It allows accountants to add and subtract peso amounts as though each peso has the same purchasing
power as any other peso at any time, This is the basis for ignoring the effects of inflation in the accounting records.

NEED FOR GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

In a sole proprietorship, adherence to proper accounting rules is important even though the owner is usually deeply
involved in the firm’s activities and is the person primarily interested in its financial affairs. However, creditors, suppliers,
and others must also be able to rely on the financial statements prepared for a sole proprietorship. When the business is
a partnership or a corporation, it is even more important that operations be properly accounted for because owners are
unlikely to be intimately involved in the activities of the firm. Generally accepted accounting principles make financial
statement meaningful and useful, regardless of the type of business organization.

The various needs for reliable financial information can be satisfied only if there are rules, procedures, and principles of
accounting that are generally accepted and used. if each entity made up its own rules, there could be no basis for
comparing the earnings and financial position of different firms. Even the records and reports of a particular entity could
not be compared for different periods unless accounting principles were applied consistently. in addition, users of
financial statements would probably be misinformed and misled.

DEVELOPMENT OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Many of today's accounting principles were developed over a period of years in response to the changing needs for
business reports. The process has worked very much like this: A particular procedure is devised by an accountant as a
solution to a specific problem. Then, other accountants find the procedure suitable for their problems and start to use it.
Eventually the procedure may become widely used and may be recognized by professional accountants, accounting
writers, and organizations that are responsible for developing generally accepted accounting principles. Other
accounting principles have resulted from a decision by authoritative, rule-making bodies such as International
Accounting Standards Board to select one of several alternative methods being used in practice. In other cases, rule-
making bodies have developed standards on the basis of logic or deductive reasoning because no clearly defined
practices were being used to account for certain types of transaction or events.

Businesses and the environment in which they operate are constantly changing. The economy, technology, and laws
change. Therefore, financial information and the methods of presenting that information must change to meet the
needs of the people who use the information. Generally accepted accounting principles are changed and refined as
accountants respond to the changing environment.

BASIC PRINCIPLES (objective 2.2)

Accounting practices follow certain guidelines. The set of guidelines and procedures that constitute acceptable
accounting practice at a given time is GAAP, which stands for generally accepted accounting principles. In order to
generate information that is useful to the users of financial statements, accountants rely upon the following principles:
(CREAM-OH)

Objectivity Principle. Accounting records and statements are based on the most reliable data available so that they will
be as accurate and as useful as possible. Reliable data are verifiable when they can be confirmed by independent
observers. Ideally, accounting records are based on information that flows from activities documented by objective
evidence. Without this principle, accounting records would be based on whims and opinions and is therefore subject to
disputes.

Historical Cost. This principle states that acquired assets should be recorded at their actual cost and not at what
management thinks they are worth as at reporting date.

Revenue Recognition Principle. Revenue is to be recognized in the accounting period when goods are delivered or
services are rendered or performed.

Expense Recognition Principle. Expenses should be recognized in the accounting period in which goods and services are
used up to produce revenue and not when the entity pays for those goods and services.

Adequate Disclosure. Requires that all relevant information that would affect the user's understanding and assessment
of the accounting entity be disclosed in the financial statements.

Materiality. Financial reporting is only concerned with information that is significant enough to affect evaluations and
decisions. Materiality depends on the size and nature of the item judged in the particular circumstances of its omission.
in deciding whether an item or an aggregate of items is material, the nature and size of the item are evaluated together.
Depending on the circumstances, either the nature or the size of the item could be the determining factor.

Consistency Principle. The firms should use the same accounting method from period to period to achieve comparability
over time within a single enterprise. However, 'changes are permitted if justifiable and disclosed in the financial
statements.

Entity Concept
Assume Bob, a local landscaping business owner, decides to branch out and buy another existing business: a concrete
company. This way his concrete company can pour footings and walkways and his landscaping business can landscape
around them. Since Bob owns both companies personally, he thinks that he can combine both companies accounting
records into one Quickbooks file. According to the business entity concept, both of these companies are separate
entities and must be accounted for separately even though Bob is the owner of both companies. If Bob's landscaping
company had bought the concrete company, both companies would have merged and could be reported together.

Jim, an owner of a pizza shop, decides to buy a new delivery car. Since the company was low on cash, Jim decided to
pay for the car himself out of his personal bank account. Jim intends to add the car to the balance sheet of the pizza
shop. The economic entity principle requires Jim and his company to keep activities separated, so the car must remain
a personal vehicle unless Jim contributes it to the company or the company buys it from Jim personally.
Periodicity Concept
The indefinite life of the business in divided into equal periods usually one year. Owner/s don’t have to wait for 5
years, a decade or until the end of the life of the business to determine whether the business earned profits or not.
The income statement is the financial statement that best shows the periodicity assumption. The income statement
presents the business performance for a given time period. A year-end income statement shows the income and
expense performanÊe for the company for the entire year. Monthly and quarterly income statements are often issued
as well. The balance sheet, on the other hand, only shows a picture of the company on a single date in time. The
balance sheet does not reflect a period of time but rather a moment in time.
Stable Monetary Unit Concept
Market conditions, technological changes and the efficiency of management would not be disclosed in the accounts

Objectivity principle
A company is trying to get financing for an extra plant expansion, but the company's bank wants to see a copy of its
financial statements before it will loan the company any money. The company's bookkeeper prints out an income
statement from its accounting system and mails it to the bank. Most likely the bank will reject this financial statement
because an independent party did not prepare it. In other words, this income statement violates the objectivity
principle.
Historical cost principle
Jeff's Construction, LLC bought a piece of equipment in 2001 for P10,000. Today this piece of equipment is only worth
P2,000. Jeff would still report the equipment at its purchase price of P10,000, less accumulated depreciation (or its
carrying value or book value) even though its current fair market value is only P2,000.
Revenue recognition principle
Pat's Retail, Inc. sells clothing from its retail outlets. A customer purchases a shirt on June 15th and pays for it on a
credit card. Pat's processes the credit card but does not actually receive the cash until July. The credit card purchase is
treated the same as cash because it is a claim to cash, so the revenue should be recorded in June when it was realized
and earned.
Expense recognition principle
Association between cause and effect
Expenses are recognized on the basis of a direct association between the expenses incurred on the basis of a direct
association between the expenses incurred and revenues earned.
For example, the sales commissions should be accounted for in the period when the products are sold, not when they
are paid.
Systematic allocation of costs
When the cost benefit several accounting periods, they should be recognized on the basis of a systematic and rational
allocation method
For example, a provision for depreciation should be made over the estimated useful life of a fixed asset.
Immediate recognition
If the expenses are expected to have no certain future benefit or are even without future benefit, they should be
written off in the current accounting period, for example, stock losses, advertising expenses and research costs
Materiality principle
Small payments such as postage, stationery and cleaning expenses should not be disclosed separately. They should be
grouped together as sundry expenses.
The cost of small-valued assets such as pencil sharpeners and paper clips should be written off to the profit and loss
account as revenue expenditures, although they can last for more than one accounting period.
Consistency principle
Bob's Computers, a computer retailer, has historically used FIFO (First In First Out) for valuing its inventory. In the last
few years, Bob's has become quite profitable and Bob's accountant suggests that Bob switch to the Average inventory
system to minimize taxable income. According to the consistency principle, Bob's can change accounting methods for
a justifiable reason. Whether minimizing taxes is a justifiable reason is debatable.
Adequate Disclosure
Lake Real Estate purchased a piece of property. A few months after the purchase, someone slipped and fell on the
property and became seriously injured. The injured party is currently suing Lake Real Estate for negligence. It is
possible that LRE will lose the lawsuit. In this case, LRE should disclose the lawsuit in the notes to financial statements.