Chapter 3: The Measurement Fundamentals of Financial Accounting

Question 1

4 basic assumptions of financial accounting

Answer 1

1) economic entity 2) fiscal period 3) going concern 4) stable dollar

Question 2

economic entity assumption

Answer 2

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

Question 3

example of economic entity assumption

Answer 3

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

Question 4

fiscal period assumption

Answer 4

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

Question 5

timely vs. objective financial info consequence

Answer 5

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

Question 6

a calendar year or fiscal year consequence

Answer 6

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

Question 7

going concern assumption

Answer 7

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

Question 8

stable dollar assumption

Answer 8

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

Question 9

purchasing power

Answer 9

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

Question 10

the limitations of financial statements

Answer 10

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).

Question 11

summary of basic assumptions

Answer 11

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).

Question 12

input market

Answer 12

the purchase of inputs (materials, labor, etc.) for its operations. input market values (costs) are normally less than output market values (prices)

Question 13

output market

Answer 13

the selling of outputs (services or inventories)

Question 14

example of the input - output market

Answer 14

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

Question 15

valuation bases

Answer 15

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

Question 16

present value

Answer 16

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

Question 17

fair market value

Answer 17

represents the current sales price in the output market

Question 18

replacement cost

Answer 18

or current cost, is the current price paid for an item in the input market

Question 19

original cost

Answer 19

represents the input price paid when the item was originally purchased

Question 20

how is the assets section of a balance sheet broken down?

Answer 20

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

Question 21

4 basic principles of financial accounting measurement

Answer 21

1) objectivity 2) matching 3) revenue recognition 4) consistency

Question 22

principle of objectivity

Answer 22

(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

Question 23

present value and the financial statements

Answer 23

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

Question 24

market value and the financial statements

Answer 24

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

Question 25

original cost and the financial statements

Answer 25

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

Question 26

the matching principle

Answer 26

states that the efforts of a given period should be matched against the benefits that result from them, underlies the measures of operating performance

Question 27

the production sales cycle

Answer 27

production of good - transfer of good or service - receipt of payment

Question 28

revenue recognition

Answer 28

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

Question 29

the principle of revenue recognition states that the following 4 criteria must be met before revenue can be included on the income statement:

Answer 29

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

Question 30

the principle of consistency

Answer 30

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

Question 31

two exceptions to basic principles

Answer 31

materiality and conservatism

Question 32

materiality

Answer 32

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

Question 33

what is a problem with materiality

Answer 33

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.”

Question 34

conservatism

Answer 34

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

Question 35

economic rationale for conservatism

Answer 35

is partially driven by the liability associated with overstating incorrectly the financial condition and performance of a company

Question 36

how do the US GAAP and the IFRA differ?

Answer 36

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