1 chapter 3 the measurement framework and mechanics of financial accounting

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CHAPTER 3CHAPTER 3

The Measurement Framework and The Measurement Framework and Mechanics of Financial AccountingMechanics of Financial Accounting

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Part 1:Part 1:

Measurement Framework for the Measurement Framework for the Financial StatementsFinancial Statements

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Basic AssumptionsBasic Assumptions

Basic assumptions are foundations of financial accounting measurements

The basic assumptions are– Economic entity– Fiscal period– Going concern– Stable dollar

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Economic EntityEconomic 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.

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Fiscal Period (Periodicity)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.

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Going ConcernGoing 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.

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Stable Dollar (Monetary Unit)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.

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Valuations on the Balance SheetValuations on the Balance SheetThere 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 inventoriesAlternative valuation bases

– Present value– Fair market value– Replacement cost– Original (historical) cost

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Present Value as a Valuation BasePresent 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.

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Fair Market Value as a Valuation BaseFair 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.

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Replacement Cost as a Valuation BaseReplacement Cost as a Valuation Base

Replacement cost is the 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.

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Historical Cost as a Valuation BaseHistorical Cost as a Valuation Base

Historical cost is the input price paid when asset originally purchased.

For example, land and property used in a company’s operations are all valued at original cost.

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The Objectivity PrincipleThe Objectivity Principle

This 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 (contractually) determined.

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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 (at delivery).

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The Matching PrincipleThe Matching Principle Matching focuses on the timing of recognition of

expenses after revenue recognition has been determined.

This principle states that the efforts of a given period (expenses) should be matched against the benefits (revenues) they generate.

For example, the 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.

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The Consistency PrincipleThe Consistency Principle 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.

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Exceptions (Constraints) to the Exceptions (Constraints) to the Basic PrinciplesBasic Principles

These exceptions contradict the basic principles, in certain circumstances.

They are:– Materiality – Conservatism

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MaterialityMaterialityMateriality (the immateriality constraint)

– Only transactions with amounts large enough to make a difference are considered material.

– 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.

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ConservatismConservatism 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.

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Part 2:Part 2:

The Mechanics of Financial The Mechanics of Financial AccountingAccounting

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Transaction AnalysisTransaction Analysis

The first step in the accounting process is transaction analysis.

This process examines relevant, objectively measurable economic events through their effect on the accounting equation:

Assets = Liabilities + Equity

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Spreadsheet Example Spreadsheet Example

Using a spreadsheet approach, analyze the transactions. (Example Co. Spreadsheet on next slide.)

Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions.

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Blank SpreadsheetBlank Spreadsheet

Cash + A/R + Land = N/P + CC + RE

1. =

2. =

3. =

4. =

5. =

6. _____ _____ _____ = _____ _____ _____

Rev.

Div.

Tot.

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Transactions in Example Co. Transactions in Example Co. Spreadsheet Spreadsheet

Business owners invest $30,000 cash in the business.

Land is purchased for $20,000 cash. Bank lends business $9,000 and receives a

promissory note. Services are rendered to customers for agreed-

upon fees of $8,000. Business pays $5,500 to vendors for supplies

used to operate the business. Profits of $500 are distributed to the business

owners in the form of a cash dividend.

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Example Co. SpreadsheetExample Co. Spreadsheet with Transactionswith Transactions

Cash + A/R + Land = N/P + CC + RE

1. =

2. =

3. =

4. =

5. =

6. _____ _____ _____ = _____ _____ _____

30,000 30,000(20,000) 20,000

9,000 9,0008,000 8,000 Rev.

(5,500) (5,500) Exp.

(500) (500) Div.

Tot. 13,000 + 8,000 + 20,000 = 9,000 + 30,000 + 2,000

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Example Co. Financial StatementsExample Co. Financial Statements

Income Statement

Revenues $8,000

Expenses 5,500

Net Income $2,500

Statement of Retained Earnings

RE (beginning) $ 0

Add: Net Income 2,500

Less: Dividends (500)

RE (ending) $2,000

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Exercise 4-2 Financial StatementsExercise 4-2 Financial Statements Balance SheetAssets Cash $13,000

A/R 8,000Land 20,000

Total $41,000

Liabilities and S.E.N/P $ 9,000CC 30,000RE (ending) 2,000Total $41,000

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Now look at Example Co. SpreadsheetNow look at Example Co. Spreadsheet

Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.

Therefore accountants use a “double entry” system based on debits and credits.

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Double Entry AccountingDouble Entry Accounting

Debit (dr) - means an entry to the left hand side of an account.

Credit (cr) - means an entry to the right hand side of an account.

Note that a debit or credit, per se, does not indicate increase or decrease.

To decide the effect of a debit or credit, the type of account must be considered.

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Effect of Debits and CreditsEffect of Debits and CreditsBased on the accounting equation, we

can increase or decrease various accounts depending on their classification:

Assets = Liabilities + Equity

Increase DR = CR CR

Decrease CR = DR DR

Note that we use debits and credits instead of plusses and minuses.

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The following rules can be derived from The following rules can be derived from the basic formula:the basic formula:Assets have normal debit balances and are

increased with a debit.Liabilities and equities have normal credit

balances and are increased with a credit.Revenues (a part of equity) have normal credit

balances and are increased with a credit.Expenses (which decrease equity) have normal

debit balances and are increased with a debit. Dividends (which decrease equity) have a

normal debit balance and are increased with a debit.

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The Format of a Journal EntryThe Format of a Journal Entry To initially record transactions, we use a journal

entry to represent the debits and credits. For example, in Example Co, Item 1:

Debit CreditCash 30,000

Contributed capital 30,000

Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount.

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Now back to Example Co. to Now back to Example Co. to prepare the other journal entries:prepare the other journal entries:

2: Purchased land for $20,000 cash.

Land 20,000

Cash 20,000

3: Borrowed $9,000 cash from bank.

Cash 9,000

Notes Payable 9,000

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Now back to E4-2, and prepare the Now back to E4-2, and prepare the other journal entries:other journal entries:

4: Provided services (on account) $8,000.

Accts. Receivable 8,000

Service Revenue 8,000

5: Paid $5,500 cash for expenses.

Expenses 5,500

Cash 5,500

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Now back to E4-2, and prepare the Now back to E4-2, and prepare the other journal entries:other journal entries:

6: Paid $500 cash dividend to owners.

Dividends 500

Cash 500

Note that dividends is a contra equity and reduces retained earnings.

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Example Co. T-AccountsExample Co. T-Accounts

Cash

30,000 20,0009,000

5,500

500

Bal. 13,000

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The Closing Process The Closing Process Closing is after the financial statements

have been completed.Close temporary accounts to retained

earnings, so that the balances in those accounts at the start of the next accounting period will be zero.

Temporary accounts include revenues, expenses and dividends.

The final trial balance after closing will display only permanent, balance sheet accounts.

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