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SOME FOUNDATION ACCOUNTING CONCEPTS*

INTRODUCTION Accounting is a communication system that aims to provide information about the financial performance of an entity. Performance presumes some objective or goal. The entitys objective is to maximize its value, a goal that is equivalent to creating maximum happiness/satisfaction for the entity owner(s). The profit-motivated owners happiness is financial wealth.1 In these Notes, the owners are presumed to be after maximum financial gain upon disposal of the entitys ownership. In turn, financial wealth is the result of undertaking business procedures categorized into investing, financing, and operating activities. For example, to Jollibee Food Corporation, investing activities can include acquiring things like cooking equipment, uncooked beef, potatoes, wrapping paper, disposable cups, tables and chairs. (These investments require tying up money, a process that
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Others are made happy by maximizing social or cultural well-being, whose attainment eludes easy indication through financial terms.

creates capacity-to-operate-thebusiness.) On another hand, Jollibees financing activities are those that raise funds like asking Jollibees owners to infuse capital into the enterprise, or borrowing from lenders. (Fund-raising constitutes the financing activities that result in having the ability to invest.) Finally, Jollibee, among other activities, produces beef patties or otherwise processes basic materials into the firms sellable forms, advertises and promotes its products, and sells products. These activities end up with Jollibee generating revenues. (Such manufacturing, selling and, in general, doing business, constitute the operating activities that convert the investments back to cash form. Note that such conversion releases funds previously tied up in investments.) In pursuing the wealth objective, the businessman undertakes financing, investing and operating activities. Another way of seeing these functions is: financing raises money, investing converts money into assets, and operating reconverts assets to money as a way of going for profit. Alternatively,

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financing leads to funds availability, investing creates operating capacity, and operating releases funds from asset investments (plus some more, usually called profit). The following are important concepts: (1) The three activity categories are parts of a continuing cycle to pursue wealth generation, making them inseparable and interdependent in that wealthmaking context. (2) Accounting summarizes investing and financing activities into the balance sheet, and the operating activities into the income statement. Accordingly, these two accounting reports are also inseparable and interdependent when assessing wealth generation. Obviously, the ability to earn profits is premised on having the capacity to operate. KEY ASSUMPTIONS A technical language, accounting has implicit assumptions2 on communicating performance requiring the listeners to appreciate such assumptions, lest they misinterpret what is signaled.
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Sometimes also called principles, laws, rules, conventions, or practices the significant fact being that they arose from general agreements or understanding, rather than from being naturally correct like the principles of the natural sciences.

Fortunately, what could be tricky assumptions are few. First, a common assumption is that the entity is profit-motivated. Sometimes, even accountants are uncomfortable answering: Why is the income statement (or balance sheet) prepared [automatically, it seems]; why not some other report? For another: Explain if the income statement and balance sheet should be prepared for the Red Cross. Be clear that profit motivation is generally assumed, hence the automatic-ness of the standard financial statements. Second, the time span covered by the accounting reports is short, the rule being: the length of one operating cycle (like a sequence of manufacturing and selling the product), or one 12-month year, whichever is longer of these two time spans. Thus, a bakerys income statement coverage will not exceed one year, but coverage could be considerably longer than a year for a one-project construction firm erecting a manufacturing complex. In general, though, financial reports covering longer than one year are rare. The crucial question, nevertheless, is: At what point in time can operating results be determined with certainty? For most cases, that certainty can be possible only after everything shall
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have been said and done and not any sooner! Truly, how would one evaluate the success of a firm that consistently reported profits for 99 years but lost everything on a single day after? Even so, the one-year period is universally observed, being the generally accepted practice.3 The lesson is obvious: As a basis for decisions affecting the future, be wary about the shortness of the time coverage of financial reports, particularly of the risks of extrapolating (or trending) from samples of one or a few. Remember: Confidence in projecting is positively related to the size of the sample. Due to serious misunderstandings on topics that arise due to the time period (time segmentation sounds more precise) assumption, it is justifiable to cover them now, particularly accrual accounting (as distinguished from the conventional wisdom of measuring operating results as indicated by cash flows). Accrual, the generally accepted method, is an option to measure profitability or operating performance, thereby the

This short-term syndrome is justified by the concept of trading off the dangers of indications based on insufficient observations with their timeliness/usefulness in making decisions designed to influence the final outcome. By analogy, the physician uses the patients chart of vital signs rather than looking at the record after the patients discharge (hopefully, on his feet).

issue directly affects the income statement. To re-state: The cash method of tracking profit is based on revenues being generated when the cash involved is received, and costs/expenses being incurred when cash is disbursed. To someone with insufficient knowledge of accounting, this is perfect perception since he associates profit with increased cash, and vice versa. On the other hand, accrual links revenue generation when the product is sold/delivered even if cash is not yet then collected, costs are incurred when the corresponding revenue is generated, also even if cash were paid out at a different period. Thus, the accrual-vs.-cash difference is simply a disparity of timing. In comparing accrual and cash methods, any dissimilarity between the profit (or, revenues or costs) figures will be simply due to the length of reckoning period. Put another way: Had the period been long enough (if not the entitys entire lifetime), there would have be no difference in the aggregate amounts involved.4 This suggests that the accrual methods perspective is shorter than the viewpoint of the cash basis.
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Nevertheless, the third standard accounting report on cash flows shows the cashbasis counterpart of the accrual income statement.
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Another area of frequent misunderstanding involves accountings depreciation of longterm assets. In fact, the problem likely started when the long-term asset was acquired. In accrual accounting, the entire cash payment (usually, a large amount) at acquisition time cannot be expensed since the revenues that correspond to such outlay have yet to arise, usually stretching far into the future. Hence, the outlay is recorded initially as an asset to be matched against future revenues, in portions commonly called depreciation expense aligned with the revenues stream. The less-informed commits errors of: (1) missing the point as to why an investment was recognized, rather than an expense; and (2) failing to distinguish between depreciations meaning as an everyday-English word denoting loss of market value, and its accounting meaning of allocation over time of a historical sum. The noted statement in accounting literature is eloquent: Depreciation is a process of allocation, not of [market] valuation. Third, a governing accounting 5 rule is that accounting shall recognize only events whose financial consequences can be
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objectively measured. The more notable among the consequentlyunrecognized items are goodwill and charge or cost of equity funds used (analogous to interest cost for borrowed funds used). Practically everybody (the accountant included) appreciates that funds infused by owners to enable the enterprise to invest/operate have a cost that should be recognized, if only to be able to make the net income shown by the income statement a true indicator of firm effectiveness in profit-making (especially as an entity separate from its owners). However, accountings objectivity rule that an events financial impact should be based on an arms-length transaction (preferably documented) is a formidable obstacle to enable recognizing equity funds cost. Indeed, there is no contractual payment (like loan interest) for the use of owner-sourced funds. Dividend distribution is not only discretionary but also dependent on favorable operating results. Thus, accountings net income is at best a deficient (read as overstated) measure of genuine profitability. [Since management accounting is not bound by such arms-length rule, cost of equity funds is incorporated to measure economic profit, residual income,

For reports intended for the general public, in particular

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Economic Value Added, and true profit.] In accounting theory, goodwill is recognizable as an asset (i.e., a resource with future economic value) to its owner. However, like in the earlier-discussed equity funds cost, the absence of a measuring transaction prevents accounting from recognizing valued items like prime location, high personnel morale level, and favorable reputation as intangible assets or goodwill. Fourth is the money measurement convention that is closely related to the objectivity convention. The former rule requires that, in addition to the arms-length condition, the events consequence should be measurable in money terms. Hence, personnel complement and morale will continue to be absent as balance sheet assets despite the popular adage, propagated by firms no less, that the entitys most valuable resource are its people. CONCLUDING STATEMENTS
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cations of information needs. By definition, accounting exists to fill the information needs of decision-makers, who must communicate their specifications to their accountants. Without such stipulation, accountants resort to providing conventional or general-case reports, or (perhaps worse) to secondguessing what decision-makers need. This results in information incongruences that render accounting less effective. (2) Accounting information users reveal lack of background on the subject when they expect those who prepare the reports to be fully responsible for proper information appreciation. Accounting is a technical language where some reasonable level of technical knowledge is expected of the users. A number of such technicalities are in these Notes.

Very often and unfortunately, the following practices or concepts exist. (1) Users of accounting information effectively abdicate their right6 to set the specifi6

Prepared by Prof. Gerardo Agulto, Jr. of the UP College of Business Admini-stration

Perhaps responsibility is more appropriate.

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