Fundamentals of Accounting Principles

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 entity's objective is to maximize its value, a goal that is equivalent to creating maximum happiness/satisfaction for the entity owner(s). The profit-motivated owner's happiness is financial wealth.1 In these Notes, the owners are presumed to be after maximum financial gain upon disposal of the entity's ownership.

In turn, financial wealth is the result of undertaking business procedures categorized into investing, financing, and operating activi-ties. 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 creates capacity-to-operate-the-business.)

On another hand, Jollibee's financing activities are those that raise funds like asking Jollibee's owners to infuse capital into the enterprise, or borrowing from lenders. (Fund-raising constitutes the financing activi-ties that result in having the ability to invest.)

1 Others are made happy by maximizing social or cultural well-being, whose attainment eludes easy indication through financial terms.

Finally, Jollibee, among other activities, pro-duces beef patties or otherwise processes basic materials into the firm's sellable forms, advertises and promotes its products, and sells products. These activities end up with Jollibee generating revenues. (Such manu-facturing, 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 busi-nessman undertakes financing, investing and operating activities. Another way of seeing these functions is: financing raises money, investing converts money into assets, and oper-ating re-converts assets to money as a way of going for profit. Alternatively, 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 gen-eration," making them inseparable and interdependent in that wealth-making 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 inter-dependent when assessing wealth generation. Obviously, the ability

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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. 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 state-ment and balance sheet should be prepared for the Red Cross. Be clear that profit motivation is gener-ally 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 bakery's income statement coverage will not exceed one year, but coverage could be considerably longer than a year for a one-project construc-tion 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

2 Sometimes also called principles, laws, rules, con-ventions, 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.

with certainty? For most cases, that certainty can be possible only "after everything shall 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 pro-jecting 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) assump-tion, 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 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

3 This short-term "syndrome" is justified by the concept of trading off the dangers of indications based on insufficient observations with their time-liness/usefulness in making decisions designed to influence the final outcome. By analogy, the phy-sician uses the patient's chart of vital signs rather than looking at the record – after the patient's discharge (hopefully, on his feet).

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May 2004

knowledge of accounting, this is perfect per-ception 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 entity's