The Measurement Fundamentals of Financial Accounting Presentations for Chapter 3 by Glenn Owen

Key Points Four basic assumptions of financial accounting. The markets in which business entities operate and the valuation basis used on the balance sheet. The principle of objectivity and how it determines the dollar values that appear on the financial statements. The principles of matching, revenue recognition, and consistency. Two exceptions to the principles of financial accounting measurement: materiality and conservatism.

Basic Assumptions Economic entity Fiscal period Going concern Stable dollar

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. Examples — Disney and ABC, General Electric and NBC.

Fiscal Period 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.

Going Concern The life of an economic entity is assumed to be indefinite. Assets, defined as having future economic benefit, require this assumption.

Stable Dollar The 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. This is considered an unrealistic assumption and thus places a limit on the financial statements as a tool for analysis.

Valuations on the Balance Sheet Input market – Purchase of materials, labor, overhead Output market – Sales of services or inventories Alternative valuation bases – Present value – Fair market value – Replacement cost – Original cost

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.

Fair Market Value as a Valuation Base 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.

Replacement Cost as a Valuation Base 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.

Original Cost as a Valuation Base Input price paid when originally purchased. For example, land and property used in a company’s operations are all valued at original cost.

Principles of Financial Accounting Measurement Objectivity Matching Revenue recognition Consistency

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 determined.

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.

Revenue Recognition Decide when revenue is to be recognized? Current Period Future Period 1.Significant portion of production and effort complete? 2.Amount of revenue objectively measured? 3.Major portion of costs have been incurred? 4.Collection of cash reasonably assured? 1.Significant portion of production and effort complete? 2.Amount of revenue objectively measured? 3.Major portion of costs have been incurred? 4.Collection of cash reasonably assured? Revenue YES Revenue NO

The Matching Principle This principle states that the efforts of a given period should be matched against the benefits they generate. For example, the cost of inventory is capitalized as an asset on the balance sheet and not recorded in Cost of Goods Sold until sold.

The Matching Process Incur cost in current period to generate revenue Decide what period revenue is to be recognized? Current Period Future Period Revenue Expense If future period, then capitalize cost on the balance sheet and expense in future periods If current period, then expense cost in current period Revenue Expense

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.

Exceptions to the Basic Principles Materiality – Only transactions with amounts large enough to make a difference are considered material. – Nonmaterial transactions are ignored Conservatism – When in doubt Understate assets Overstate liabilities Accelerate recognition of losses Delay recognition of gains