Slides for Class 4H ADM 545

January 31, 2002

General Principals of Accounting

• Financial Versus managerial accounting

• Principles of Accounting

• Conventions of Accounting

Financial Accounting

• Primary outputs of financial accounting are four financial statements:– Balance sheet– Statement of revenues and expenses– Statement of cash flows– Statement of changes in fund balances

• Generally accepted accounting principles (GAAP)

• What a CPA’s audit of an HCO’s financials means

Managerial Accounting

• Mainly for special financial reports not governed by GAAP

• Primarily for internal users– managers– directors

• Uniformity and comparability of financial information less important

Principles of Accounting

• Accounting entity• Money Measurement• Duality• Cost Valuation

– Required Return on investment (ROI) and Valuation Alternatives

• Accrual Accounting• Stable Monetary Unit• Fund Accounting

Accounting Entity principle

• “Specifying the entity on which the accounting will focus defines the information that is pertinent.”

• Is there a board of trustees that is legally responsible for governing the organization?

• Problem: Case where the legal entity is different from the accounting entity – Foundation that is the legal owner of hospitals– Is each of these hospitals an accounting entity?

Money Measurement

• Concern that the economic resources and obligations for accounting entities be consistently measured

• Economic Resources: “Scarce means, ... essential to economic activity” (ASSETS)

• Economic Obligations: “responsibilities to transfer resources to another entity in the future” (LIABILITIES)

• Excess of ASSETS over LIABLITIES is a residual called OWNERS EQUITY, NET ASSETS, or FUND BALANCE depending on how the accounting entity is licensed.

Duality

• The value of ASSETS must always = the value of LIABILITIES + NET ASSETS

• Thus after the monetary value of each transaction to which the accounting entity is posted to the proper accounts, the ASSETS must = the LIABILITIES + NET ASSETS on the firm’s Balance Sheet.

• What does an account in a charter of accounts look like up close?

Cost Evaluation

• Historical or acquisition costs of assets• Valuing assets based on their market value• Replacement cost valuation of assets• How the passing of time can lead to dramatic

divergences between historical and replacement costs of assets due to inflation or a decline in the purchasing power of a dollar– Remedy : Account for transactions not in dollars but

in dollars of purchasing power at a given point in time.

Required Return on Investment and Valuation Alternatives

• Cost of Capital is the price the investor must pay for the cash needed to make an investment

• The Cash flow is the revenue an entity receives from its investments in buildings, equipment, or programs

• Historical costs of Investment • Replacement cost of Investment• Current Market Value of Investment• How decisions are driven by Return the

Investment (ROI) compared to Cost of Capital• See Figure 4-1, p. 83 for explanation

Accrual Accounting

• “…transactions of a firm are recognized during the period to which they relate, not… in period in which cash is received or paid”

• Accrual accounting has its greatest impact on statements of revenues and expenses

• Income from the sale of services are called revenues and increase a firms fund balance or owners’ equity

• Costs of delivering services to patients are called expenses and decrease a firm’s fund balance or owners’ equity

Accrual Accounting (cont.)

• Transactions recorded in the period in which they relate (see Exhibit 4-3, p. 82)– billing patient charges to accounts receivable -

accounts for revenues on date services delivered – accepting supplier charges to accounts payable -

accounting for expenses on date items are delivered

• Adjustments recorded so accounts reflect current resources and obligations (see Exhibit 4-4, p. 85)– adjusting for services delivered but not billed -

revenue– adjusting for wages and benefits earned but not paid

to workers- estimate expenses accrued but not paid– adjusting for depreciation of equipment incurred but

not spent in the current time

Stable Monetary Unit

• “at the present time no adjustment to changes in the general purchasing power of that unit (dollar) is required in financial reports”

• “Currently, generally accepted accounting principles incorporate the stable monetary unit principle”

• What can happen if financial reports are based on the stable monetary unit but the firms adjust wages for inflation on the first day of the month while patients pay for delivered services at the end of the month. (See Exhibit 4-6, p. 86)

Fund Accounting

• “a system in which an entity’s assets and liabilities are segregated in the accounting records” (common for not-for-profit firms that raise capital from donors)

• ‘Duality’ theoretically must hold for each independent fund

• FASB pronouncement divides assets into one of three categories:– unrestricted net assets– temporarily restricted net assets– permanently restricted net assets

Conventions of Accounting

• “However, several widely accepted conventions modify the application of these principles in certain circumstances”

• Three conventions:– Conservatism– Materiality– Consistency