Financial accounting in an economic context 8e chapter 03

Present Value as a Valuation Baseoutflows notes receivable is calculated by determining the amount and timing of its future cash inflows and adjusting the dollar amounts for the time val

Chapter 3:

The Measurement Fundamentals

of Financial Accounting

Basic Assumptions

financial accounting measurements

– Fiscal period

– Stable dollar

Economic Entity

economic entity that can be identified

Fiscal Period (Periodicity)

 It is assumed that the life of an

economic entity can be broken down

into accounting periods

objectivity and timeliness

the calendar or fiscal year

Going Concern

 The life of an economic entity is

assumed to be indefinite

economic benefit, require this

assumption

 Allocation of costs to future periods is

supported by the going concern

assumption

Stable Dollar (Monetary Unit)

measure an economic entity’s

performance and position is assumed

stable

 If true, the monetary unit must maintain

constant purchasing power

unit’s purchasing power

 If inflation is material, the stable dollar

assumption is invalid

Valuations on the Balance Sheet

assets and liabilities on the balance sheet:

– Input market: cost to purchase materials,

Present Value as a Valuation Base

outflows

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

valued at net realizable value which

approximates fair market value

Replacement Cost as a Valuation Base

the current price paid in the input

market

original cost or replacement cost,

whichever is lower

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.

 Under IFRS, certain companies are allowed

to value property, plant, and equipment at fair

market value.

 “Cash equivalent price” is used to calculate

historical cost when cash is not paid (as in the issue of a liability to purchase the asset)

Principles of Financial Accounting

Measurement

 When transactions occur, we must decide when to recognize the transactions in the financial

statements, and how to measure the transactions.

 The principles of recognition and measurement

are:

– Objectivity

– Revenue recognition

– Matching

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

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 (at

delivery).

Exercise 3-5

Cascades Enterprises ordered 4,000 brackets from

McKey and Company on December 1, 2011, for a contracted price of $40,000

Dec 1, 20011: Cascades orders brackets Jan 17, 2012: McKey completed manufacturing Feb 9, 2012: McKey delivered the brackets

Mar 14, 2012: McKey received a check for $40,000

 a Assume that McKey prepares monthly

income statements In which month should

it recognize the $40,000 revenue?

would recognize revenue is at the time of

delivery So in this case McKey and

Company would recognize revenue in

February

 b What are the four revenue recognition

criteria?

The four criteria for recognizing revenue are (1) the company has completed a

significant portion of the production and

sales effort, (2) the amount of revenue can

be objectively measured, (3) the company has incurred the majority of costs, and

remaining costs can be reasonably

estimated, and (4) cash collection is

reasonably assured

 c Are there conditions under which the

revenue could be recognized in a month different from the one chosen in (a)?

production, (2) at the completion of

production, (3) at the point of delivery, or (4) when the cash is collected Since the

production and sales effort was not really

complete until McKey shipped the brackets

on February 9, February 9 appears to be the

 d Why is the timing of revenue

recognition important?

the timing of revenue recognition due to incentives provided by contracts For

example, the managers may be paid a

bonus based upon accounting income

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.

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

Exceptions (Constraints) to the

Basic Principles

principles, in certain circumstances

– Materiality

 Materiality (the immateriality constraint)

enough to make a difference are

considered material

alternative treatments

year life, but the materiality constraint allows

a company to expense the item in the year purchased

– 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.

International Perspective

financial statements

where creditors provide large amounts of

capital, companies prepare reports that

contain intentional understatement of

assets and overstatement of liabilities

IFRS, but many believe that the additional discretion available to management under

Fundamental Differences – US GAAP

use of fair market values unless they can

be objectively determined

sheet values for changes in market value

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