Financial accounting 9th jamie pratt chapter 03

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Chapter 3: The Measurement Fundamentals of Financial Accounting Basic Assumptions of Financial Accounting • Basic assumptions are foundations of financial accounting measurements • The basic assumptions are: • • • • 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, Comcast and NBC 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 Going Concern  The life of an economic entity is assumed to be indefinite  Assets, defined as having future economic benefit, require this assumption  Allocation of costs to future periods is supported by the going concern assumption Stable Dollar (Monetary Unit) • 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 • If inflation is material, the stable dollar assumption is invalid 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  Fair market value  Replacement cost  Original (historical) 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  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 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 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) Revenue Recognition and Matching 18 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 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 Exceptions (Constraints) to the Basic Principles • These exceptions contradict the basic principles, in certain circumstances They are: • • Materiality Conservatism Materiality  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 Conservatism  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 International Perspective  Conservatism is pervasive in some foreign financial statements  Some companies prepare reports that contain intentional understatement of assets and overstatement of liabilities  Such practices are more difficult under IFRS, but many believe that the additional discretion available to management under IFRS is still used to reduce reported earnings Fundamental Differences – US GAAP and IFRS  IFRS is “principles-based” while US GAAP is “rules- based”  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 Copyright © 2014 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make backup copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein .. .Chapter 3: The Measurement Fundamentals of Financial Accounting Basic Assumptions of Financial Accounting • Basic assumptions are foundations of financial accounting measurements... 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,... the scope of financial statements • Examples — Disney and ABC, Comcast and NBC Fiscal Period (Periodicity)  It is assumed that the life of an economic entity can be broken down into accounting
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