Learning MBA Master Degree

BASIC CONCEPTS

TEACHER: Hello, Student. Here we are again, this time to discuss Financial Management. Eight Modules, eight homework assignments and a final exam are ahead of us!

STUDENT: Hi, Teacher. Fine, we will cross each bridge as we get to it. Let’s start with Module I; I am ready for it.

TEACHER: Very well. Let me begin by telling you that the PRINCIPLES of accounting are built on a foundation of a few BASIC CONCEPTS. They are so basic that most accountants do not consciously think of them; they are regarded as being self-evident, obvious, to be taken for granted.

STUDENT: Just assume that I am a non-accountant (which I am) and tell me more, please.

TEACHER: Sure. As a non-accountant you will not find these concepts to be self-evident. Accounting could be based on quite different concepts, and indeed some accounting theorists argue that certain of the present concepts are wrong and should be changed.

Government agencies and professional associations are constantly issuing new rules or modifying existing ones. In general, the words "Generally Accepted Accounting Principles" (GAAP) describe this set of rules.

Accounting Principles are not an exact science. They have been created by men and evolve according to the circumstances. They also differ very much in detail between different types of industries or commercial activities. And naturally, they differ a lot between countries. It is, in short, an evolutionary process. The Financial Accounting Standards Board (FASB) was established in the US a long time ago, in 1973. It is a non-governmental organization and in consequence its decisions are not legally enforceable unless the government rules that they must be complied with. The FASB is financed by private companies and accounting professionals, individuals and organizations.

In order to understand accounting as it exists in a given moment, however, one must understand what the underlying concepts currently are. It is a fact that different concepts would lead to different accounting results.

The Financial Accounting Standards Board has not published a list of basic concepts, and indeed no authoritative list exists. Also, other names are often used for notions that we call "concepts": postulates, basic assumptions, basic features, underly1ng principles, fundamentals or conventions, and more.

STUDENT: Given this level of confusion, how will we deal with the problem of discussing the "Basic Concepts"?

TEACHER: We will be fine if we stick with ten basic concepts, and these are the ones we will deal with in this course. Let’s begin with the most important one.

No. 1: The Money Measurement Concept

In financial accounting, a record is made only of those facts that can be expressed in monetary terms. In fact, this seems to be the only way to provide a common unit of measurement by means of which different facts about a business can added and subtracted.

STUDENT: I see. I may own a house, a car, some furniture, a bicycle, etc. But unless I list these goods giving them a monetary value, there is no way they can be added up to compute my "net worth".

TEACHER: I see you got the idea. But you probably also noticed that this concept imposes a severe limitation on the scope of an accounting report. Continuing with the example of yourself, accounting does not record any fact about your health, your professional qualifications, the relationship you have with your partner (spouse) if you are married. It does not mention the fact that you may be about to be fired from your job or that you got a wonderful offer for a new position at double your present salary.

STUDENT: I can see that accounting therefore does not give a complete description of the condition of a business. I conclude that the reader of an accounting report should not expect to find in it all, or even the most relevant facts about a business. Now, what about the changes in purchasing power of a currency, say the dollar or the euro?

TEACHER: Good point. In general money values are expressed in terms of its value at the time an event is recorded in the accounts. Subsequent changes in the purchasing power of money do not affect this amount. In most advanced economies, in spite of the fact that everyone knows that the purchasing power of money changes, no adjustments are made. In many less developed economies where inflation has been very high, adjustments to monetary values are made according to indexes issued by tax authorities.

No. 2: The Entity Concept

Let’s define the Entity Concept formally: "Accounts are kept for business entities, as distinguished from the persons who are associated with these entities." Is that definition clear to you?

STUDENT: Sure. In recording events or situations in accounting, the relevant question is: how do these events affect the business? It is not relevant how they affect the persons who own, operate, or otherwise are associated with the business.

TEACHER: Correct. If you own a business and you take cash out of your business, for example, the accounting records show that the business has less cash than previously, without considering that the real effect of this event on yourself, the owner, may have been negligible. If you are the sole owner, while you have taken cash out of your business and put it into you personal "pocket," it remains your cash.

STUDENT: I realize that it is sometimes difficult to define with precision the business entity for which a set of accounts is kept. Assume that my wife and I own a small unincorporated pet store. Legally there is no distinction between the financial affairs of the store and those of the owners, my wife and myself. In spite of that, I am aware that a set of accounts must be kept for the store as a separate business entity.

TEACHER: Yes, especially because the tax authorities insist on it. The events reflected in the store’s set of accounts must be those of the store only. It is apparent that the necessity for making such a distinction between the business entity and its owners can create problems. Let’s assume that you and your wife live on the business premises. How much of the expenses and taxes of these premises are properly part of the expenses of the business, and how much are personal expenses of the family?

STUDENT: Anyway, this difficulty is only important in those businesses in which there is a close relationship between the business and the people who own it, right?

TEACHER: True. In the case of a corporation, the distinction is often quite easily made. A corporation is a legal entity separate from the persons who own it, and the accounts of many corporations correspond exact1y to the scope of the legal entity.

Still, there may be complications. In the case of a group of legally separate corporations that are related to one another, the whole group may be treated as a single business entity for reporting purposes, publishing consolidated accounting statements.

STUDENT: A system that can be used to fool stockholders, as the famous scandal of ENRON has demonstrated.

TEACHER: A perfect example. Enron shifted large expenses and debts to subsidiaries and then failed to include them in the consolidated statements arguing that they were "not material". The auditors, Andersen, did not object to this obviously incorrect procedure. The Enron collapse has raised many questions about corporate financial practices, most notably corporate accounting.

It is a fact that an important purpose of financial accounting is to provide the basis for judging professional management’s performance. The managers of a business are entrusted with funds supplied by owners, banks, and others. Management is responsible for the honest and efficient use of these funds, and financial accounting reports are in part designed to show how well this responsibility has been discharged.

STUDENT: Do you think that the collapse of Enron originated significant changes to the accounting industry?

TEACHER: Many functions of FASB have now been effectively taken over by the Securities and Exchange Commission. There is a very important institution, the International Accounting Standards Board in London; I’d say that the international standards board is going to achieve more importance in America than it has in the past.

STUDENT: Returning to the concept of entity, how do you define with precision what an "entity" is ?

TEACHER: An entity, more exactly an "accounting entity", is any organization or activity for which accounting reports are prepared.

STUDENT: You mean an entity is always a business, firm or company?

TEACHER: We will focus on business companies, but accounting entities include governments, churches, universities, etc.

No. 3: The Going-Concern Concept

Accounting assumes that the business will continue to operate for an indefinitely long period in the future. Why is this important? Because if the business is about to be liquidated or sold, it is obvious that accounting would attempt to measure what the business is currently worth to a buyer rather than deal with "historical" cost of assets.

On the other hand, if the assumption is that the business will continue to operate indefinitely, this is not done.

STUDENT: Sure, the common sense approach to evaluate a company is to consider it a "machine" for creating values.

TEACHER: Correct. The success of this "machine" is measured by the difference between the value of its outputs (sales of goods and services) and the cost of the input used in creating those outputs.

STUDENT: Which of course is called "profit". But what about inputs (materials, etc) that have been purchased but not yet used in creating outputs?

TEACHER: The normal procedure is to show them on the accounting records, not at their market or resale value, but rather at their cost. The former value is irrelevant, since it is assumed that they will not be sold in their present state but transformed into outputs to be sold as such.

No. 4: The Cost Concept

The resources that a business owns are called its assets. They consist of money, land, buildings, machinery and other tangible or intangible property.

STUDENT: Intangible?

TEACHER: We can mention options to purchase something at a certain price, copyrights and patents as examples of intangible property or "property rights."

Anyway, the normal practice is that an asset is entered on the accounting records at the price paid for it -that is, at its cost. This figure is the basis for all subsequent accounting for the asset.

STUDENT: OK, but the fact is that the real worth of an asset may change as time passes. Is this reflected in the accounting records?

TEACHER: Ordinarily not. This is the difference between the accounting concept of cost and the concept of value. In common usage, "value" means what something is currently worth. Let me give you an example. A business buys a plot of land, paying $50,000 for it and this asset is recorded in the accounts of the business at the same amount.

Subsequent changes in the market value of this land would normally not be recorded in the accounts. The land might be worth double as much or half as much some time after the purchase but normally no change would be made in the accounting records to reflect this changes in market value of the asset.

STUDENT: I noticed you used the word "normally" twice in the last sentence. Are there "not normal" situations?

TEACHER: Indeed, there are some situations in which accounting records are changed to reflect changes in market value. We will describe them later in this course. Any comments on what we have discussed up to now?

STUDENT: Well, you said the amounts at which assets are listed in the accounts of a company do not indicate what the assets could be sold for. This may be misleading; it is likely that some persons reading accounting reports may think that there is a close correspondence between the amount at which an asset appears on these reports and the actual value of the asset.

TEACHER: Yes, this is a common error that is taken advantage of by "company riders". Often the shares of a company are undervalued because many people conclude from the accounting reports that the company has a low "book value". But the truth may be that property (say, land) is reported at cost and this figure might be many times lower than the current market value. Company riders have made lots of money by purchasing the undervalued shares, taking over the company and selling off the valuable assets at a large profit.

STUDENT: Is there never a correspondence between accounting figures and market values?

TEACHER: Actually there is a correspondence for what are called monetary assets; money itself or assets such as bonds or shares that can easily converted into money and the value of which can easily established.

STUDENT: Is it a fact then that, due to the cost concept, all assets -except monetary assets- remain on the accounting records at their original purchase price for as long as the company owns them?

TEACHER: Certainly not, but the changes are not normally caused by actual market valuations, but by a process called depreciation to be discussed later.

STUDENT: Does the cost concept mean that if the company pays nothing for an item it acquires over time, this item will usually not appear on the accounting records as an asset?

TEACHER: Right. The know-how hat is built up as the business operates, a favorable location that becomes of increasing importance as time goes on, or a good reputation with its customers, do not appear as assets in the accounts of the company.

STUDENT: I have seen the term "goodwill" in some accounting reports.

TEACHER: Yes, on some accounting reports the term "goodwill" appears. Goodwill appears in the accounts of the company only when the company has actually purchased (paid for) some intangible and valuable property right. Unless the business has actually purchased such intangibles, however, no item for "goodwill" is shown in the accounts.

The cost concept provides a relatively objective foundation for accounting. A "market value" or "current worth" concept would be difficult to apply.

No. 5: The Dual-Aspect Concept

The resources owned by a business are called "assets." The claims of various parties against these assets are called "equities." There are two types of equities:

1. Liabilities, which are the claims of creditors, i.e., everyone other than the owners of the business; and
2. Owners' equity, which is the claim of the owners of the business. Remember that the owners and the business are treated as separate entities.

Now, Student, can you draw some conclusions from what I just said?

STUDENT: I’ll try.

1. It is a fact that all the assets of a business are claimed by someone (either by the owners or by some outside party), and
2. the total of these claims cannot exceed the amount of assets to be claimed.

My conclusion is that Assets must be equal to Equities; Assets = Liabilities

TEACHER: Excellent. All accounting procedures are derived from this fundamental equation. If we discriminate between third party and owner’s claims, we can also express the equation as Assets = Liabilities + Owners' Equity.

STUDENT: So, if I start a business with $ 5,000, the initial balance sheet of the business will show assets of $5,000 and an owners equity or "capital" of $5,000, reflecting my claim against the business.

TEACHER: Right, and what if as a next step the firm borrows $1,000 from your brother?

STUDENT: Now the business will show a total asset figure of $6,000, a liability to my brother of $1,000 and an owners equity or "capital" of $5,000. As said before,

Assets = Liabilities + Owners' Equity / $6,000=$1,000+$5,000.

As a result of borrowing the $1,000 I have affected two items: assets and liabilities. Am I right in assuming that this is the famous "double-entry bookkeeping system" adopted by the Italian merchants in the 15th. century?

TEACHER: Correct. Every event that is recorded in the accounts affects at least two items. Accounting is therefore properly called a double-entry system.

No. 6: The Conservatism Concept

The conservatism concept means that when the accountant has a reasonable choice as to how a given event could be recorded, he should choose the alternative resulting in a lower, rather than higher, asset amount, or owners' equity amount. In short, the axiom is "Anticipate no profit, and provide for all possible losses."

STUDENT: Does this modify the Cost Concept?

TEACHER: Yes, to a certain degree. Inventories (material held for sale, supplies, and so forth) should be reported, not at their cost in accordance with the cost concept, but rather at the lower of their cost or their current replacement value.

STUDENT: Forgive me, but this sounds a bit unrealistic to me. Is it actually done in practice?

TEACHER: You are right. The conservatism concept is applied much less strongly now than was the case a few decades ago when it was a common practice to report some assets at far less than either their cost or their current market value. Nevertheless, few would question the fact that the concept does exist and that it is important. After the many corporate high profile accounting scandals (Enron, Xerox, etc.) the conservatism concept may come back into fashion again.

THE BALANCE SHEET

A balance sheet shows the financial position of an accounting entity as of a specified moment of time. It is therefore a status report, rather than a flow report.

STUDENT: Could be compare it with a still picture taken at a given moment?

TEACHER: Yes we could, and it is a good way to illustrate it.

A balance sheet for the Gadget Corporation is shown below.

Let us first examine this balance sheet in terms of the basic concepts listed above.

1. The figures are expressed in money and reflect only those matters that can be measured in money amounts.
2. The entity involved is the Gadget Corporation, and the balance sheet refers only to the entity and not to any individuals or different entities related to the corporation.
3. The statement assumes that the Gadget Corporation is a going concern.
4. The asset amounts shown are based on the cost concept.

The dual-aspect concept is apparent; the assets listed on one side of this balance sheet are equal in total to the equities (liabilities and shareholders' equity) listed on the other side.

STUDENT: Does the fact that the two sides of the Balance Sheet add up to the same total have any special meaning?

TEACHER: No. This MUST be so by definition and does no tell anything about the company's financial situation. Now, what else do you notice in the illustrated Balance Sheet?

STUDENT: I see that Assets are listed on the left-hand side, and equities are listed on the right-hand side. But in other cases I have seen Assets listed at the top of the page and equities underneath them.

TEACHER: Correct: In the United States assets are always listed on the left-hand side. In certain other countries, assets are listed on the right-hand side -and equities on the left-hand side. Of course, none of these differences has any real significance.
The balance sheet we are observing gives a minimum amount of detail and the terms used are common ones, and they are described briefly below. More detailed descriptions will be given later on.

Assets

Assets are economic resources owned by an entity whose cost at the time of acquisition can be objectively measured. The three key points in this definition are the following: (1) an asset must be an economic resource; (2) the resource must be owned; and (3) its value at the time of acquisition must be objectively measurable.

STUDENT: What do you mean exactly by "economic resource"?

TEACHER: A resource is an economic resource if it provides future benefits to the entity. Resources provide future benefits under any of three conditions: (1) they are money or can be converted to money; (2) they are goods which are expected to be sold; or (3) they are expected to be used in future activities of the entity.

Current Assets

Current assets include cash and other assets that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business or within one year if the normal operating cycle is within one year.

The distinction between current assets and non-current assets is important because lenders and investors pay a lot of attention to this figure.

1. Cash consists of funds that are immediately available. Usually, most of these funds are on deposit in checking accounts in banks.
2. Marketable securities are investments which are both readily marketable and which are expected to be converted into cash within a year. According to generally accepted accounting principles, marketable securities are reported on the balance sheet at their cost or their current market value, whichever is lower, unless the decline in market value is believed to be only temporary.




3. Accounts receivable are amounts owed to the company, usually by its customers. Sometimes this item is broken down into trade accounts receivable and other accounts receivable; the former refers to amounts owed by customers, and the latter refers to amounts owed by employees and others.
4. As defined by the FASB the term inventory means "the aggregate of those items of tangible personal property which (1) are held for sale in the ordinary course of business, (2) are in process of production for such sale, or (3), are to be currently consumed in the production of goods or services to be available for sale."


The item prepaid expenses and deferred charges represents certain assets, usually of an intangible nature, whose usefulness will expire in the near future. An example is an insurance policy. A business pays for insurance protection in advance, often for a three-year or a five-year period. Its right to this protection is an asset -a valuable, owned resource- but this right will expire within a fairly short period of time. Prepaid expenses and deferred charges are reported at the cost of the unexpired service. Thus, if a business has purchased insurance protection for a three-year period, paying $1,200, and one year has expired as of the balance sheet date, the asset is reported at two thirds of its cost, or $800. The $800 represents the cost of the protection for the next two years. The distinction between "prepaid expenses" and "deferred charge" is not important.
Fixed Assets

Fixed assets are tangible, relatively long-lived resources. The term Property, Plant and Equipment is also frequently used for this category, and is more descriptive of its nature. The business has acquired these assets, ordinarily, in order to use them in the production of other goods and services. If the assets are held for resale they are classified as inventory, even though they are long-lived assets.

STUDENT: You mean that if an automobile is owned by a car manufacturer to sell it, it is inventory. A similar car the manufacturer uses for transportation is a fixed asset.

TEACHER: Correct. In the example we see that "land, buildings, and equipment" is reported at cost, and the next item, "accumulated depreciation," means that a portion of the original cost has been already allocated as a cost of doing business. Depreciation will be discussed in detail later in this course.

Other Assets

1. Investments are securities of one company owned by another in order either to control the other company or in the anticipation of earning a return from the investment. They are therefore to be distinguished from "marketable securities," which is an item in the current asset section of the balance sheet, and which is intended to reflect the temporary use of excess cash.
2. Intangible assets include goodwill, patents, copyrights, leases, licenses, franchises, etc.


Liabilities

In general, liabilities are the entity's obligations to pay money or to provide goods or services. Unless otherwise noted, the individual liabilities shown on the balance sheet are not claims against any specific asset or group of assets. Thus, although accounts payable typically arise through the purchase of material for inventory, accounts payable are claims against all the assets, not merely against inventories.

STUDENT: Would a mortgage be an example of a liability that is a claim against a specific asset?

TEACHER: Yes, but even in this case it is shown separately on the right-hand side of the balance sheet, and not as a deduction from the asset amount to which it relates.

Current Liabilities

Current liabilities are obligations which are expected to be satisfied either by the use of assets classified as current in the same balance sheet, or by the creation of other current liabilities or obligations that are expected to be satisfied within a relatively short period of time, usually one year.

Accounts payable

Accounts payable represent the claims of vendors and others. Usually these claims are unsecured. If the claim was supported by an IOU or some other written acknowledgment of debt, the item would be called notes payable, bank drafts payable, or some other term that describes the nature of the obligation.

Estimated tax liability is the amount owed the government for taxes.

Accrued expenses

Accrued expenses are the contrary of prepaid expenses. An example is the wages and salaries owed to employees for work they have performed but for which they have not been paid.

Deferred income represents the liability that arises because the company has received advance payment for a service it has agreed to render in the future. An example is rent collected in advance.

Other Liabilities

Other liabilities are obligations which are not due within one year.

Owners' Equity

The owners' equity section of the balance sheet shows the amount the owners have invested in the entity. The terminology used in this section of the balance sheet varies with different forms of organization,

In a corporation, the ownership interest is evidenced by shares of stock, and the owners' equity section of its balance sheet is therefore usually named Shareholders' or Stockholder’s Equity.

The shareholders' equity is divided into two main categories.

The first category, called paid-in capital or contributed capital, is the amount which the owners have invested direct1v in the business.

The second category of shareholders' equity is called Retained Earnings. The owners' equity increases through earnings and decreases when earnings are paid out in the form of dividends. The difference between the total earnings to date and the total amount of dividends to date is retained earnings.