1. 1 CHAPTER 3 The Measurement Framework and Mechanics of Financial Accounting

2. 2 Part 1: Measurement Framework for the Financial Statements

3. 3 Basic Assumptions Basic assumptions are foundations of financial accounting measurements The basic assumptions are – Economic entity – Fiscal period – Going concern – Stable dollar

4. 4 Economic Entity A company is assumed to be a separate economic entity that can be identified and measured. This concept helps determine the scope of financial statements.

5. 5 Fiscal Period (Periodicity) It is assumed that the life of an economic entity can be broken down into accounting periods. The result is a trade-off between objectivity and timeliness. Alternative accounting periods include the calendar or fiscal year.

6. 6 Going Concern The life of an economic entity is assumed to be indefinite. Assets, defined as having future economic benefit, require this assumption. Allocation of costs to future periods is supported by the going concern assumption.

7. 7 Stable Dollar (Monetary Unit) T he value of the monetary unit used to measure an economic entity’s performance and position is assumed stable. If true, the monetary unit must maintain constant purchasing power. Inflation, however, changes the monetary unit’s purchasing power. If inflation is material, the stable dollar assumption is invalid.

8. 8 Valuations on the Balance Sheet There are a number of ways to value assets and liabilities on the balance sheet: – Input market: cost to purchase materials, labor, overhead – Output market: value received from sales of services or inventories Alternative valuation bases – Present value – Fair market value – Replacement cost – Original (historical) cost

9. 9 Present Value as a Valuation Base Discounted future cash inflows and outflows For example, the present value of a notes receivable is calculated by determining the amount and timing of its future cash inflows and adjusting the dollar amounts for the time value of money.

10. 10 Fair Market Value as a Valuation Base Fair market value is measured by the sales price or the value of goods and services in the output market. For example, accounts receivable are valued at net realizable value which approximates fair market value.

11. 11 Replacement Cost as a Valuation Base Replacement cost is the current cost or the current price paid in the input market. For example, inventories are valued at original cost or replacement cost, whichever is lower.

12. 12 Historical Cost as a Valuation Base Historical cost is the input price paid when asset originally purchased. For example, land and property used in a company’s operations are all valued at original cost.

13. 13 The Objectivity Principle This principle requires that the values of transactions and the assets and liabilities created by them be verifiable and backed by documentation. For example, present value is only used when future cash flows can be reasonably (contractually) determined.

14. 14 The Revenue Recognition Principle This principle determines when revenues can be recognized. This principle triggers the matching principle, which is necessary for determining the measure of performance. The most common point of revenue recognition is when goods or services are transferred or provided to the buyer (at delivery).

15. 15 The Matching Principle Matching focuses on the timing of recognition of expenses after revenue recognition has been determined. This principle states that the efforts of a given period (expenses) should be matched against the benefits (revenues) they generate. For example, the cost of inventory is initially capitalized as an asset on the balance sheet; it is not recorded in Cost of Goods Sold (expense) until the sale is recognized.

16. 16 The Consistency Principle Generally accepted accounting principles allow a number of different, acceptable methods of accounting. This principle states that companies should choose a set of methods and use them from one period to the next. For example, a change in the method of accounting for inventory would violate the consistency principle. However, certain changes are permitted with sufficient disclosure regarding the change.

17. 17 Exceptions (Constraints) to the Basic Principles These exceptions contradict the basic principles, in certain circumstances. They are: – Materiality – Conservatism

18. 18 Materiality Materiality (the immateriality constraint) – Only transactions with amounts large enough to make a difference are considered material. – Nonmaterial transactions can be given alternative treatments For example, a trash can might have a five year life, but the materiality constraint allows a company to expense the item in the year purchased.

19. 19 Conservatism The conservatism constraint permits the choice of the more conservative alternative in certain situations where two alternatives exist regarding the valuation of a transaction. Conservatism - When in doubt: – Understate assets – Overstate liabilities – Accelerate recognition of losses – Delay recognition of gains For example, “lower of cost or market” is used to value inventory. Problem: Some managers have abused the conservatism constraint in earnings management.

20. 20 Part 2: The Mechanics of Financial Accounting

21. 21 Transaction Analysis The first step in the accounting process is transaction analysis. This process examines relevant, objectively measurable economic events through their effect on the accounting equation: Assets = Liabilities + Equity

22. 22 Spreadsheet Example Spreadsheet Example Using a spreadsheet approach, analyze the transactions. (Example Co. Spreadsheet on next slide.) Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions.

23. 23 Blank Spreadsheet Blank Spreadsheet Cash + A/R + Land = N/P + CC + RE 1. = 2. = 3. = 4. = 5. = 6. _____ _____ _____ = _____ _____ _____ Rev. Div. Tot.

24. 24 Transactions in Example Co. Spreadsheet Business owners invest $30,000 cash in the business. Land is purchased for $20,000 cash. Bank lends business $9,000 and receives a promissory note. Services are rendered to customers for agreed- upon fees of $8,000. Business pays $5,500 to vendors for supplies used to operate the business. Profits of $500 are distributed to the business owners in the form of a cash dividend.

25. 25 Example Co. Spreadsheet with Transactions Example Co. Spreadsheet with Transactions Cash + A/R + Land = N/P + CC + RE 1. = 2. = 3. = 4. = 5. = 6. _____ _____ _____ = _____ _____ _____ 30,000 (20,000)20,000 9,000 8,000 8,000 Rev. (5,500)(5,500) Exp. (500)(500) Div. Tot. 13,000 + 8,000 + 20,000 = 9,000 + 30,000 + 2,000

26. 26 Example Co. Financial Statements Income Statement Revenues$8,000 Expenses 5,500 Net Income$2,500 Statement of Retained Earnings RE (beginning) $ 0 Add: Net Income2,500 Less: Dividends(500) RE (ending)$2,000

27. 27 Exercise 4-2 Financial Statements Balance Sheet Assets Cash$13,000 A/R 8,000 Land 20,000 Total$41,000 Liabilities and S.E. N/P$ 9,000 CC 30,000 RE (ending) 2,000 Total$41,000

28. 28 Now look at Example Co. Spreadsheet Now look at Example Co. Spreadsheet Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient. Therefore accountants use a “double entry” system based on debits and credits.

29. 29 Double Entry Accounting Debit (dr) - means an entry to the left hand side of an account. Credit (cr) - means an entry to the right hand side of an account. Note that a debit or credit, per se, does not indicate increase or decrease. To decide the effect of a debit or credit, the type of account must be considered.

30. 30 Effect of Debits and Credits Based on the accounting equation, we can increase or decrease various accounts depending on their classification: Assets = Liabilities + Equity Increase DR = CR CR Decrease CR = DR DR Note that we use debits and credits instead of plusses and minuses.

31. 31 The following rules can be derived from the basic formula: Assets have normal debit balances and are increased with a debit. Liabilities and equities have normal credit balances and are increased with a credit. Revenues (a part of equity) have normal credit balances and are increased with a credit. Expenses (which decrease equity) have normal debit balances and are increased with a debit. Dividends (which decrease equity) have a normal debit balance and are increased with a debit.

32. 32 The Format of a Journal Entry To initially record transactions, we use a journal entry to represent the debits and credits. For example, in Example Co, Item 1: Debit Credit Cash 30,000 Contributed capital 30,000 Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount.

33. 33 Now back to Example Co. to prepare the other journal entries: 2: Purchased land for $20,000 cash. Land20,000 Cash 20,000 3: Borrowed $9,000 cash from bank. Cash 9,000 Notes Payable 9,000

34. 34 Now back to E4-2, and prepare the other journal entries: 4: Provided services (on account) $8,000. Accts. Receivable8,000 Service Revenue8,000 5: Paid $5,500 cash for expenses. Expenses5,500 Cash5,500

35. 35 Now back to E4-2, and prepare the other journal entries: 6: Paid $500 cash dividend to owners. Dividends 500 Cash 500 Note that dividends is a contra equity and reduces retained earnings.

36. 36 Example Co. T-Accounts Cash 30,000 20,000 9,000 5,500 500 Bal. 13,000

37. 37 The Closing Process Closing is after the financial statements have been completed. Close temporary accounts to retained earnings, so that the balances in those accounts at the start of the next accounting period will be zero. Temporary accounts include revenues, expenses and dividends. The final trial balance after closing will display only permanent, balance sheet accounts.

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