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1、Chapter 3 The Measurement Fundamentals of Financial AccountingKey PointsFour basic assumptions of financial accounting.The valuation bases 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

2、, revenue recognition, and consistency.Two exceptions to the principles of financial accounting measurement: materiality and conservatism.Assumptions of Financial AccountingEconomic entityFiscal periodGoing concernStable dollarEconomic EntityA company is assumed to be a separate economic entity that

3、 can be identified and measured. Individual companies must be entities in and of themselves, separate and distinct from both their owners and all other entities.This concept helps determine the scope of financial statements.Examples subsidiaries and consolidated financial statementsWalt Disney and A

4、BC, General Electric and NBC.Fiscal PeriodIt is assumed that the operating life of an economic entity can be divided into time periods over which measures of performance can be developed and applied.The result is a trade-off between timeliness and objectivity.Alternative accounting periods include t

5、he calendar or fiscal year.Going ConcernThe life of an economic entity is assumed to extend beyond the current period and will continue indefinitely.Assets, defined as having future economic benefit, require this assumption.Without this assumption, the measurement of asset will be different from his

6、torical cost.Examples: the cost of equipmentStable DollarThe value of the monetary unit used to measure an economic entitys performance and position is assumed stable. If true, the monetary unit must maintain constant purchasing power.Inflation, however, changes the monetary units purchasing power.T

7、his is considered an unrealistic assumption and thus places a limit on the financial statements as a tool for analysis.Summary of Basic Assumption Assumption Definition Economic entityProfit-seeking entities, which are separate and distinct from their owners and other entities, can be identified and

8、 measured.Fiscal period The life of the economic entity can be divided into fiscal periods, and the performance and financial position of the entity can be measured during each of those periods.Going concernThe life of the economic entity will extend beyond the current fiscal period.Stable dollarThe

9、 performance and financial position of the entity can be measured in terms of a monetary unit that maintains constant purchasing power across fiscal periods.Valuations on the Balance SheetInput marketPurchase of materials, labor, overheadOutput marketSales of services or inventoriesFour Alternative

10、valuation basesPresent valueFair market valueReplacement costOriginal costPresent ValueDiscounted future cash inflows and outflows from input and output marketFor example, the present value of a notes receivable is calculated by determining the amount and timing of its future cash inflows and adjust

11、ing the dollar amounts for the time value of money.Attention and illustration: Appendix A (P474) shows about the time value of money.Fair Market ValueCurrent sales price or value of goods and services in the output market.For example, accounts receivable are valued at net realizable value which appr

12、oximates fair market value.Replacement Cost Current cost to replace or the current price to be paid in the input market.For example, inventories are valued at original cost or replacement cost, whichever is lower (LCM).Original CostInput price paid when originally purchased or historical cost in inp

13、ut marketsFor example, land and property used in a companys operations are all valued at original cost.Example: P54Figure 3-3: valuation bases on the balance sheet P55FMV (or face value, net realizable value): Cash; Short-term investment; Account receivable; Current liabilities etc.LCM (Lower-of-cos

14、t-or-market): InventoryPV: Long-term notes receivable; long-term notes payable; Bonds payable; Mortgage payable etc.OC (or historical cost, net book value): Prepaid expenses; Land investment; Long-term securities investment; Property, plant, and equipment; Intangible assets etc.Illustration and Summ

15、ary of Valuation BasesThe Principles of Financial Accounting MeasurementObjectivityMatchingRevenue recognitionConsistencyObjectivityThis principle requires that the values of transactions and the assets and liabilities created by them be verifiable and reliable and backed by documentation.For exampl

16、e Present value is only used when future cash flows can be objectively determined.While market values (including replacement cost) are sometimes objectively determinable, in most situations they are not objective enough for use in the financial statements.Original costs can be objectively verified a

17、nd supported by documented evidence.Revenue RecognitionThis 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 tr

18、ansferred or provided to the buyer.Four criteria must be met before revenue can be included in the e statement: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 major portion of the costs has been incurre

19、d, and the remaining costs can be reasonably estimated.4. The eventual collection of the cash is reasonably assured. MatchingThis principle states that the efforts of a given period should be matched against the benefits that result from them.If the revenues are generated, the cost is treated as an

20、expense, appearing on the e statement of the current period.If the revenue are expected to be realized in future periods, the cost is considered an asset, or capitalized, and appears on the balance sheet. In future periods, as the revenues are realized, the assets are converted to expenses appearing

21、 on the e statements of the future periods. 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 ProcessIncur costThe Matching ProcessIncur costPeriod revenue is generated?The Matching ProcessIncur costPerio

22、d revenue is generated?ExpenseCurrentperiodThe Matching ProcessIncur costPeriod revenue is generated?ExpenseCapitalizeFutureperiodThe Matching ProcessIncur costPeriod revenue is generated?ExpenseCapitalize?ConsistencyGenerally accepted accounting principles allow a number of different, acceptable me

23、thods 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.Consistency does not mean that companies never change accounting me

24、thods. If management can convince the independent auditor that the environment facing the company has changed to the point that an alternative accounting method is appropriate, the company is allowed to switch.The change is described in the footnotes and mentioned in the auditors report, and its eff

25、ect on e is disclosed in a separate category on the e statement.Two Exceptions to the Basic Principles MaterialityOnly those transactions dealing with dollar amounts large enough to make a difference to financial statement users need be accounted for in a manner consistent with the principles of fin

26、ancial accounting.Immaterial transactions are ignored, that means management is allowed to account for them as expediently as possible.For example, the cost of a wastebasket is immediately treated as an expense.In determining materiality, not only must the size of an item be considered, but its natu

27、re can also be important.ConservatismWhen in doubt, financial statements shouldUnderstate assetsOverstate liabilitiesAccelerate recognition of lossesDelay recognition of gainsConservatism does not suggest that the financial statements should be intentionally understated. The economic rationale of conservatis