Accounting for Investments: Equities, Futures and Options, Volume I

By R. Venkata Subramani
Copyright © 2009 John Wiley & Sons (Asia) Pte. Ltd.

APPENDIX
A
Basics of Accounting Theory

BASIC ASSUMPTIONS
Basic assumptions def ne the basic objectives of accounting practice. They provide
ground rules, which are essential characteristics of a traditional accounting model.

Accounting Entity Assumption

According to this assumption, the business is considered to be separate from its individual
owners. This is to ensure that the proprietor does not include any of his personal or family
f nancial activities in the results of the business. The business transactions are identif ed,
measured, and communicated as accounting data that is separate from the owner.

Money Measurement Assumption

This assumption states that not all activities of the business are recorded in the accounting
books. Only those transactions that are measured in monetary terms are recorded. For
example, wages paid can be measured in terms of money and hence it is recorded. But
employee compatibility with each other cannot be measured in terms of money and is
not recorded in the accounting records.

Accounting Period Assumption

The periodicity assumption refers to the qualitative characteristic of timeliness. The
users require periodic information to make decisions. A natural business year is the
12-month period or 52 weeks or 365 days, where the business activities end for the year
and a new accounting year begins. If the annual time period ends on December 31, it
is known as calendar year. But some companies have a f scal year that corresponds to
their nature of business.

Going Concern Assumption

The going concern assumption is necessary as it is an anticipation that a business entity
will continue to operate indef nitely. A company is begun with the hope of a long life
and continuing its existence into the foreseeable future. The corollary of this assump-
tion is that the expenses are classif ed as capital expenditure and revenue expenditure:
capital expenditures are long standing while revenue expenditure is supposed to be
utilized within the accounting period.
603
604 Accounting for Investments

BASIC CONCEPTS
Basic concepts indicate which events will be accounted for and in what manner. They
form the underlying principles of f nancial accounting practices.

Dual Aspect Concept

The dual aspect refers to the double-entry system, which ref ects that each transaction
has two sides to it. Both the increases and decreases of each transaction that forms an
element of a company’s f nancial position are recorded.

Revenue Realization Concept

Revenues are inf ows of assets resulting from providing a service or product to a
customer. This concept states that the revenue is recognized in the period it is earned,
regardless of when cash actually is received. The two criteria that must be satisf ed for
revenue to be recognized are:
1. The earning process is complete or at least virtually complete.
2. There is reasonable certainty that the asset to be received is collectable.
In satisfying the f rst criterion, the seller has done something; satisfying the second
criterion demonstrates that the buyer has done something.

Historical Cost Concept

The historical cost concept refers to the measurement of assets and liabilities based on
their original transaction value on the day on which they were acquired. For example,
an asset that cost $200,000 at the time of purchase may have a present market value of
$600,000. For the purpose of recording in books, the asset will be valued at $200,000,
which is the money actually given at the time of purchase.

Matching Concept
This concept states that expenses are recognized in the same period as their related
revenues. While revenue is recognized according to the realization concept, the
matching concept requires that all expenses incurred in generating the same revenue
be recognized at the same time.

Objectivity Concept
According to this concept, each business transaction requires proper evidence to
support it. For example, the historical cost of a land is highly verif able. The cost of the
land can be traced back to the time when it was purchased.

Full Disclosure Concept

The full disclosure concept means that the financial statements must include
all relevant information that can influence the decision-making process of their
users. This supplemental information gives more insight to the information that
Basics of Accounting Theory 605

is available in the financial statements. The supplemental information is disclosed

in a number of ways:
• Parenthetical comments.
• Disclosure notes.
• Supplemental f nancial statements.

BASIC PRINCIPLES OF ACCOUNTING

Cost Benefit Principle
The information gathering process is done to assess both costs and benef ts of a
proposed accounting principle. This principle states that in order to apply a principle
in practice, the cost of doing it should not exceed its benef t. If the cost exceeds the
benef t, the principle is modif ed to achieve more benef t from it.

Materiality Principle
Any information that will have an effect on its decision makers is known as material
information. Materiality is mainly dependent on the relative amount of money involved
in the transaction. It also depends on the nature of the item. The context of materiality
is left to the judgment of the company that prepares the f nancial statement.

Consistency Principle
The f nancial statements provided by the company should be consistent year after
year. Each rule, concept, and principle that is used by the company must be observed
and applied every year. Comparison of f nancial statement between different
accounting periods will be signif cant only if the practices followed by the company
are consistent.

Prudence Principle
The principle of conservatism or principle of prudence requires that the company
make prudent accounting choices and estimates for the future. It is always better to
understate assets and overstate liabilities. For example, a part of the accounts receivable
may not be collected, and this is known as bad debts. So the accountant would have to
make provisions for such a situation.

ACCOUNTING MODEL
Financial Position
The balance sheet or statement of f nancial position shows the assets, liabilities, and
shareholders’ equity at a specif c point in time. It gives a snapshot of the company’s
f nancial position in a particular time period. This provides a wealth of information to
external decision makers.
One of the important features of a balance sheet is that it helps the decision makers
to assess what resources are available to generate future cash f ows. It also provides
information about liquidity and long-term solvency.
606 Accounting for Investments

Assets are the resources of a company. The company’s obligations are known as
liabilities. Owners’ equity refers to the assets that are available after all obligations have
been satisf ed.

Results of Operation
The record of the amount of net income earned by a company during a period of time
is known as the income statement or results of operation. It represents the measurement
of economic performance of a company. It is in effect a summarization of revenues
generated and the costs incurred to generate the revenues. Net income or net loss is
derived from the difference between revenues and expenses. Net income is used to
evaluate the health and performance of a business.
Revenues refer to the inf ow of resources when goods are sold or services are
performed. It represents an increase in total assets. The outf ow of resources to generate
such revenue is referred to as expenses.

Statement of Cash Flows

The statement of cash f ows captures the cash inf ows and cash outf ows of a company
for a specif ed period of time. In other words, it is the summarization of transactions that
caused cash amounts to change for a reporting period. The cash f ows are classif ed into
three main categories: operating activities, investing activities, and f nancing activities.
1. Cash f ows that appear in day-to-day operations are known as operating activities—
for example, paying wages, paying taxes, interest, dividends, and so on.
2. Cash f ows related to the acquisition and disposition of land, buildings, and
equipment, are known as investing activities. They entail the buying and selling
of long-term assets.
3. The external f nancing of a company is known as financing activities—for
example, cash invested by owners, cash paid back to creditors, and so on.

ELEMENTS OF BASIC REPORTING

Assets
Assets of a company include cash, accounts receivable, inventory, land, building,
machinery, and intangible items. In other words, assets represent everything that a
business owns. Each asset must be assigned a monetary value.
Assets are classif ed into two categories:
1. Tangible assets.
2. Intangible assets.
Tangible assets are those that have some physical existence—in other words,
something that can be touched and felt, for example, buildings, plants, machinery, and
so on. Tangible assets are further classif ed into two types:
1. Fixed assets—those that have a permanent life and cannot be converted into
cash immediately (e.g., equipment).
2. Current assets—those that can be converted into cash within a year (e.g.,
accounts receivable).
Basics of Accounting Theory 607

Intangible assets are those that do not have a physical existence and cannot be touched
or felt. They include such things as goodwill, patents, copyrights, and so on.

Liabilities
Liabilities are amounts that the company owes, such as accounts payable, loans, and so
on. Liabilities are also classif ed into three categories:
1. Long-term.
2. Current.
3. Contingent.
Debt or other obligations that will not be paid off within one year are known as long-
term liabilities. Liabilities that are repayable within one year are known as current liabilities.
A liability that can be anticipated to arise in the future is known as contingent liability.
FASB Concepts Statement 6, Elements of Financial Statements, describes the
characteristics of assets and liabilities as follows:
An asset has three essential characteristics:
(a) it embodies a probable future benef t that involves a capacity, singly or in
combination with other assets, to contribute directly or indirectly to future net
cash inf ows,
(b) a particular entity can obtain the benef t and control others’ access to it; and
(c) the transaction or other event giving rise to the entity’s right to or control of the
benef t has already occurred.
A liability has three essential characteristics:
(a) it embodies a present duty or responsibility to one or more other entities that
entails settlement by probable future transfer or use of assets at a specif ed or
determinable date, on occurrence of a specif ed event, or on demand,
(b) the duty or responsibility obligates a particular entity, leaving it little or no
discretion to avoid the future sacrif ce; and
(c) the transaction or other event obligating the entity has already happened.

Owners’ Equity
Owners’ equity equals total assets minus total liabilities. To start a business, investors
put in the money initially in return for part ownership. Ownership restricted to a single
person is known as sole proprietorship; ownership by a small group is a partnership;
and ownership that is represented by transferable shares is known as a corporation.
Equity increases through investments made by owners. Such investment involves
a transfer of resources by the investor to the company in exchange for ownership
rights. For example, a person becomes a shareholder of a company by the exchange of
resources for the issuance of stock by the company. Owners’ equity increases also when
prof ts are generated by the business and retained for the business’s use. The amount of
prof t that is not distributed to the investors is known as retained earnings.
A decrease in equity is a result of distributions to owners. In other words, owners’
equity decreases when investors take back part of their investment. In the case of a
corporation, distribution to owners is in the form of dividends. Owners’ equity is also
decreased when the company generates a loss instead of a prof t.
608 Accounting for Investments

Income
Revenue or income refers to the inf ow of resources when goods are sold or services are
performed. It represents an increase in total assets. Assets are increased by borrowing
or through money invested by people. Similarly, assets also increase when the company
provides a product or service for which customers pay. But these assets are not tied
to any liability obligation; hence the assets belong to the company and result in an
increase in owners’ equity. Companies also earn revenue by charging interest or by col-
lecting rent. For the good sold or services performed, income is in the form of cash or
accounts receivable.

Expenses
The outf ow of resources to generate revenue is referred to as expenses. This means the
amount of assets used to conduct business operations—for example, payment of salary
to employees.
One important feature of expenses is that they represent outf ows of resources
incurred in the process of generating revenues. Expenses are paid for by cash or as a
credit, wherein cash payment is to be made at a later date.

Other Comprehensive Income

Items incurred or earned outside of normal operations are known as other compre-
hensive income. Examples of other comprehensive income include unrealized gains
and losses on available-for-sale securities, gains and losses resulting from converting
foreign currency subsidiaries to parent currency, gains and losses on derivatives held as
cash f ow hedges, and so on.

Off-balance-sheet Items
These are items that are not reported as part of the balance sheet, but are reported
in the footnotes to the f nancial statements. There must be certain legitimate reasons
to report an item as off-balance-sheet. The items most commonly reported are lease
agreements, pension assets and liabilities, investment in joint ventures, and securitiza-
tion of assets.
In the case of lease agreements, if the contract does not have a buyout option at the
end of the lease, then it cannot become a personal asset. So at the end of the lease the
item must be returned and hence it cannot become an asset of your own.
The assets of pensions are put into a trust or invested in a f nancial vehicle. These
assets belong to the employees, so it is not right for the companies to claim them as
their own.