The Measurement The Measurement Fundamentals of Financial Fundamentals of Financial

AccountingAccounting

Presentations for Chapter 3 by Glenn Owen

Key PointsKey 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 AssumptionsBasic AssumptionsEconomic entityFiscal periodGoing concernStable dollar

Economic EntityEconomic EntityA 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 PeriodFiscal PeriodIt 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 ConcernGoing ConcernThe life of an economic entity is assumed to

be indefinite.Assets, defined as having future economic

benefit, require this assumption.

Stable DollarStable 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 Valuations on the Balance SheetBalance 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 Present Value as a Valuation Baseas 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 Fair Market Value as a Valuation Baseas 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 Replacement Cost as a Valuation Baseas 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 Original Cost as a Valuation BaseValuation 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 Principles of Financial Accounting MeasurementAccounting Measurement

ObjectivityMatchingRevenue recognitionConsistency

The Objectivity PrincipleThe Objectivity PrincipleThis 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 The Revenue Recognition PrincipleRecognition 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 RecognitionRevenue Recognition

Decide when revenue is to be

recognized?

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 PrincipleThe Matching PrincipleThis 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 ProcessThe Matching Process

Incur cost in current

period to generate revenue

Incur cost in current

period to generate revenue

Decide what period revenue is to be recognized?

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 future period, then capitalize cost on the

balance sheet and expense in future periods

If current period, then expense cost in current period

If current period, then expense cost in current period

Revenue

Expense

The Consistency PrincipleThe Consistency PrincipleGenerally 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 Exceptions to the Basic PrinciplesBasic 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

C O P Y R I G H T

C o p y r i g h t © 2 0 0 3 , J o h n W i l e y & S o n s , I n c . A l l r i g h t s r e s e r v e d .R e p r o d u c t i o n o r t r a n s l a t i o n o f t h i s w o r k b e y o n d t h a t p e r m i t t e d i n S e c t i o n 1 1 7 o f t h e 1 9 7 6 U n i t e d S t a t e s C o p y r i g h t A c t w i t h o u t t h ee x p r e s s w r i t t e n p e r m i s s i o n o f t h e c o p y r i g h t o w n e r i s u n l a w f u l . R e q u e s t f o r f u r t h e r i n f o r m a t i o n s h o u l d b e a d d r e s s e d t o t h e P e r m i s s i o n s D e p a r t m e n t , J o h n W i l e y & S o n s , I n c . T h e p u r c h a s e r m a y m a k e b a c k - u p c o p i e s f o r h i s / h e r o w n u s e o n l y a n d n o t f o r d i s t r i b u t i o n o r r e s a l e . T h e P u b l i s h e r a s s u m e s n o r e s p o n s i b i l i t yf o r e r r o r s , o m i s s i o n s , o r d a m a g e s , c a u s e d b y t h e u s e o f t h e s e p r o g r a m s o r f r o m t h e u s e o f t h e i n f o r m a t i o n c o n t a i n e d h e r e i n .