Financial accounting 9th jamie pratt chapter 03

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 mar

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Basic Assumptions of Financial Accounting

• Basic assumptions are foundations of

financial accounting measurements

• The basic assumptions are:

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,

Comcast and NBC.

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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

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 Allocation of costs to future periods is supported

by the going concern assumption

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Stable Dollar (Monetary Unit)

• The value of the monetary unit used to measure an economic entity’s performance and position is

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 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

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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

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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

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Original (Historical) Cost as a Valuation Base

 Original 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)

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Valuation Basis

on the Balance Sheet In the interest

of fair financial reporting,

different accounts are valued using different

methods.

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:

The Principle of Objectivity

 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

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The Principle of Matching

• Matching focuses on the timing of recognition of

expenses

• This principle states that the efforts of a given period (expenses) should be matched against the benefits (revenues) they generate.

• Examples:

• 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.

• Salaries and wages of employees are accrued as expenses in the period when the employees provide the work, even if they aren’t paid until after the date of the financial statements.

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The Principle of Revenue Recognition

 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)

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Revenue Recognition and

Matching

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Exercise 3-5

Cascades Enterprises ordered 4,000 brackets from

McKey and Company on December 1, 2014, for a contracted price of $40,000

Dec 1, 2014: Cascades orders brackets Jan 17, 2015: McKey completed manufacturing Feb 9, 2015: McKey delivered the brackets

Mar 14, 2015: 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?

The most common point at which a company would recognize revenue is at the time of delivery/shipment

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 title of goods has transferred

to the buyer, 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)?

Revenue could be recognized (1) during

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 appropriate date to recognize the revenue.

d Why is the timing of revenue recognition important?

McKey's managers could be interested in the timing of revenue recognition due to incentives provided by contracts For example, the

managers may be paid a bonus based upon accounting income

Revenue recognition must portray a fair

representation of the company’s financial

activities to external users of the statements

The Principle of Consistency

 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.

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Exceptions (Constraints) to the Basic Principles

• These exceptions contradict the basic principles, in certain circumstances

They are:

• Materiality

• Conservatism

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 Materiality

o Only transactions with amounts large enough to make a difference are considered material (a reasonable investor would think it is important)

o 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.

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 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.

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Fundamental Differences – US GAAP and IFRS

 IFRS is “principles-based” while US GAAP is based”

“rules- IFRS leaves more discretion to management

 US GAAP generally does not allow the use of fair market values unless they can be objectively

determined

 IFRS allows adjustments to the balance sheet values for changes in market value

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