Fundamental Financial Concepts

• Author: Vern Krishna
• Pages: 15-47

Chapter II: Fundamental Financial Concepts 15

Chapter II: Fundamental

Financial Concepts

Finance comprises a spectrum of accounting and nancial princi-

ples, concepts, conventions, postulates, and axioms that, collectively,

provide the reference points by which accounting bodies, regula-

tory agencies, and academics set new standards. Hence, we need

to understand the fundamental concepts and their limitations. We

examine these concepts in this chapter as a stepping stone to dis-

cussing nancial statements in later chapters.

A. MONETARY MEASUREMENT

Financial statements record only facts that we can express in mone-

tary terms. ey do not record other information that may be highly

relevant in determining the viability or success of an enterprise. For

example, a law rm’s balance sheet will show only how much prop-

erty the rm owns as assets: cash, receivables, work in process, in-

vestments, computers, furniture, art, land and buildings. e rm’s

 See, generally, Canadian Institute of Chartered Accountants, CICA Hand-

book — Accounting, loose-leaf (Toronto: Canadian Institute of Chartered

Accountants, ), Part II, section  [CICA Handbook]. e Financial

Accounting Standards Board (FASB) in the United States has issued vari-

ous Statements of Financial Accounting Concepts that address some of these

fundamental issues, such as the purpose of nancial statements, the nature

of assets and liabilities, and the kind of information useful for users of

nancial statements.

16 Understanding Financial Statements

balance sheet will not disclose anything about its “real,” and most

valuable, assets: the talent pool of its lawyers and sta — the assets

that give it value and generate its revenues.

e following example shows three estimates of brand size and

diversity of brand values for some of America’s largest corporations

in .

Example

Company Interbrand Millward Brown Brand Finance

(US$ billion)

Coca-Cola 71.86

IBM 69.91 100.85 36.16

Microsoft 59.09 78.24 42.81

Google 55.32 111.50 44.29

GE 42.81

Apple 153.29

McDonald’s 81.02

Walmart 36.22

Vodafone 30.67

erefore, in analyzing an entity, we need to be mindful of the lim-

its of nancial statements and evaluate both its nancial and non-

nancial assets.

) Constant Dollars

Another aspect of money measurement is that conventional nan-

cial statements assume that all dollars are equal and have constant

values. For example, if a business bought  acres of land in down-

town Toronto in  for  million and purchased one acre of adja-

cent land in  for  million, the asset (land) on its balance sheet

will show at a cost of  million. us, for accounting purposes, the

s dollar is assumed to be the same as the  dollar. However,

recent developments in International Financial Reporting Stan-

dards (IFRS) require disclosure of market values for certain assets.

Chapter II: Fundamental Financial Concepts 17

As a matter of empirical evidence, we know that the assumption

of constant dollars is not accurate. In interpreting assets on the bal-

ance sheet we must be sensitive to their nature and the mixing of

dollars. It does not matter much if we mix assets such as accounts

receivable because of their short life. A March accounts receivable

mixed with a July accounts receivable does not distort the nancial

statements because the change in value, assuming normal ina-

tion, is slight. e issue is important, however, when we mix capital

assets (such as land) that are on the books for many years, some-

times decades or even centuries.

) Historical Costs

Subject to IFRS requirements, the convention is that nancial state-

ments are prepared primarily based on the historical cost of assets

at the time that the business acquires them. ereaer, the asset

may appreciate or depreciate in value. With certain exceptions for

diminution in value of property, plant, and equipment, for example,

subsequent changes do not usually show up in the balance sheet.

Financial statements do not generally reect the market value of a

business or its assets.

Example

If a company acquires a building for $10 million, the asset is on the

balance sheet at that cost (value). The company will depreciate the

building over its useful life by allocating the cost of the asset to several

accounting periods. For example, if the building has an estimated useful

life (with zero residual value) of fty years, it may allocate $200,000 per

year for depreciation. If the building appreciates in value to $80 million

in thirty years, the balance sheet will still reect its original cost less

accumulated depreciation. Unless revalued, the potential gain of $70

million will not show on a conventional balance sheet prepared on the

basis of historical costs.

e historical cost model can produce hysterical results. For ex-

ample, the Disney company carries all the land on its books at their

 CICA Handbook, Part II, section , para .