Chapter 3: The Measurement Fundamentals of Financial Accounting Flashcards
4 basic assumptions of financial accounting
1) economic entity 2) fiscal period 3) going concern 4) stable dollar
economic entity assumption
the process of providing information about profit-seeking entities implicitly assumes that they 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
example of economic entity assumption
Walt Disney acquired common stock of Capital Cities/ABC Inc. Due to this, it included all of ABC’s liabilities and assets on its consolidated balance sheet. For financial reporting purposes, ABC, which publishes its own separate financial statements, is included within the economic entity referred to as The Walt Disney Company
fiscal period assumption
states that the operating life of an economic entity can be divided into time periods over which such measures can be developed and applied. once the object of measurement has been identified (economic entity), we must recognize that to be useful, measures of performance and financial position must be available on a timely basis. most corporations, for example, prepare annual financial statements, providing yearly feedback and performance measure to their shareholders
timely vs. objective financial info consequence
the fiscal period assumption introduces a trade-off between the timelines of accounting information and its objectivity. users need timely information, and thus, they generally prefer fiscal periods that are shorter. However, as the fiscal period gets shorter, the applications of certain accounting methods become more arbitrary and subjective
a calendar year or fiscal year consequence
companies choose the dates of their reporting cycles. most major US companies report on the calendar year. however, a number of companies report on 12 month periods that end on dates OTHER than December 31, called fiscal years. in most cases companies choose this financial reporting cycle because its operations are seasonal, and the financial statements are more meaningful if the reporting period includes the entire season
going concern assumption
follows logically from the fiscal year assumption. if we assume that an entity’s life can be divided into fiscal periods, we must further assume that its life extends beyond the current period. in other words, we assume that the entity will not discontinue operations at the end of the current period over which its performance is being measured
stable dollar assumption
is implicit in the measures of performance and financial condition used to evaluate and control management’s decisions. the logical unit of measurement for the financial performance and condition of a company is the monetary unit used in the economic transactions entered into by that company
purchasing power
the amount of goods and services it can buy at a given point in time. during inflation, which has come to be a fact of life, the purchasing power of the dollar decreases steadily. therefore, the financial statements, which are based on the assumption that the purchasing power of the dollar is constant can be seriously misstated
the limitations of financial statements
the stable dollar assumption is one instance in which the financial statements are based on an unrealistic assumption. the FASB required certain large US companies to provide information about the effects of inflation in their annual reports (this was costly and wasn’t valuable to many users of these statements).
summary of basic assumptions
in summary, we have assumed the existence of a separate, measurable business entity (economic entity), whose infinite life (going concern) can be broken down into fiscal periods (fiscal period) and whose transactions can be measured in stable dollars (stable dollar).
input market
the purchase of inputs (materials, labor, etc.) for its operations. input market values (costs) are normally less than output market values (prices)
output market
the selling of outputs (services or inventories)
example of the input - output market
Toyota may purchase a new Camry for $19,000 in the input market and may sell it to you, a customer, for $23,000 in the output market
valuation bases
used tot determine the dollar amounts attached to the accounts on the balance sheet. they are 1) present value 2) fair market value 3) replacement cost 4) original cost
present value
represents the discounted future cash flows associated with a particular financial statement item. the present value of a note receivable, for example, is calculated by determining the amount and timing of its future cash inflows and then adjusting the dollar amounts for the time value of money
fair market value
represents the current sales price in the output market
replacement cost
or current cost, is the current price paid for an item in the input market
original cost
represents the input price paid when the item was originally purchased
how is the assets section of a balance sheet broken down?
current assets at the top, then long term investments, then PPE, then intangible assets. below these are the liabilities and shareholder’s equity section, which go from current liabilities to long term liabilities. the assets section should always be equal to L and SE section
4 basic principles of financial accounting measurement
1) objectivity 2) matching 3) revenue recognition 4) consistency
principle of objectivity
(most important) states that financial accounting info must be verifiable and reliable. it requires that the values of transactions and of the assets and liabilities created by them be objectively determined and backed by documented evidence
present value and the financial statements
the principle of objectivity ensures that present value is normally not used as the valuation base for assets and liabilities. in some cases, however, the future cash flows associated with certain assets and liabilities are predictable enough to allow for sufficiently objective present value calculations
market value and the financial statements
using market value as a valuation base for the accounts on the financial statements can be attractive because, in many cases, market value represents the best estimate of present value. in addition, fair market value is often more objective than present value. market prices for the equity securities of major US companies
original cost and the financial statements
under normal circumstances prepaid expenses, land, securities, property, plant, and equipment, and intangible assets are value at original cost, the cost when the asset was originally acquire, or net book value, which is original cost adjusted for depreciation or amortization. original costs play an important role because they can be objectively verified and supported by documented evidence
the matching principle
states that the efforts of a given period should be matched against the benefits that result from them, underlies the measures of operating performance
the production sales cycle
production of good - transfer of good or service - receipt of payment
revenue recognition
the most common point of revenue recognition is when the good or service is transferred to the buyer. at this point, the company has normally completed the earning process and it entitled to recognize the revenue
the principle of revenue recognition states that the following 4 criteria must be met before revenue can be included on the income 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) in the case of physical goods, the title has transferred; in the case of services, the service has been performed 4) the eventual collection of the cash is reasonably assured
the principle of consistency
states that although there is considerable choice among methods, companies should choose a set of methods and use them from one period to the next. its primary rationale is that consistency helps investors, creditors, and other interested parties to compare measures of performance and financial positions across time periods comparability across time periods is critical to effective financial analysis
two exceptions to basic principles
materiality and conservatism
materiality
states that only those transactions dealing with dollar amounts large enough to make a difference to financial statement users need to be accounted for in a manor consistent with the principles of financial accounting. the dollar amounts of some transactions are so small that the method of accounting has virtually no impact on the financial statements and, thus, no effect on the related evaluations and control decisions
what is a problem with materiality
it requires judgements that can differ considerably among investors, creditors, managers, auditors, and others. the supreme court defines a material item as one to which “there is substantial likelihood that a reasonable investor would attach importance i determining whether to purchase a security.”
conservatism
is practical and has evolved over time in response to cost/benefit considerations. in its simplest form, conservatism states that, when in doubt, financial statements should understate assets, overstate liabilities, accelerate the recognition of losses, and delay the recognition of gains
economic rationale for conservatism
is partially driven by the liability associated with overstating incorrectly the financial condition and performance of a company
how do the US GAAP and the IFRA differ?
1) IFRS is more “principles based” while the US GAAP tends to be more “rules based.” 2) under GAAP, the principle of objectivity ensures that fair market values are not used unless they can objectively be determined. IFRS seems less dependent on the principle of objectivity and the concept of conservatism. the IFRS allows adjustments to the balance sheet values of assets like long term investments, property, plant, and equipment, inventories, and certain intangible assets
