CHAPTER 3
The Measurement Fundamentals of Financial Accounting
SYNOPSIS
In this chapter, the author discusses the measurement fundamentals of financial accounting
which consist of the basic assumptions, valuation issues, principles, and exceptions underlying
the financial statements.
Fundamental Differences between US GAAP and IFRS are discussed.
The ethics vignette considers the case of an industry leader (Microsoft) which formerly used
ultra-conservative accounting for revenue recognition and has recently switched to more
aggressive revenue recognition accounting.
The Internet research exercise directs the student to the SEC Edgar Database to obtain
information about filings in general and specific information for a particular company, Microsoft.
The following key points are emphasized in Chapter 3:
1.
Four basic assumptions of financial accounting.
2.
The markets in which business entities operate and the valuation bases used on the
balance sheet.
3.
The principle of objectivity and how it determines the dollar values that appear on the
financial statements.
4.
The principles of matching, revenue recognition, and consistency.
5.
Two exceptions to the principles of financial accounting measurement: materiality and
conservatism.
6.
Fundamental differences between US GAAP and IFRS.
TEXT/LECTURE OUTLINE
The measurement fundamentals of financial accounting.
I. Assumptions of financial accounting.
A.
The assumptions concern the business environment and provide a foundation for
creating an accounting system.
B.
The basic assumptions of financial accounting.
1.
Economic entity assumption.
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2.
3.
4.
II.
a)
Investors are interested in obtaining information about a particular profitseeking entity. Consequently, the economic activities of that entity must
be able to be identified and separated from the economic activities of its
owners and all other entities.
b)
Economic units versus legal units.
Fiscal period assumption.
a)
The life of the entity can be broken into arbitrary time periods (fiscal
periods) over which its performance and financial position can be
measured.
b)
This assumption is necessary to provide timely performance measures to
investors. However, there is a tradeoff between timely and objective
financial information.
Going concern assumption.
a)
The life of the economic entity is assumed to extend indefinitely beyond
the current fiscal period.
b)
This assumption allows accountants to adhere to accrual accounting and
to record assets and liabilities.
Stable dollar assumption.
a)
An entity's performance and financial position is measured in monetary
units. The monetary unit is assumed to possess stable purchasing power
over time.
b)
The assumption is inconsistent with the reality of inflation. Consequently,
this assumption leads to financial statements that "distort" a company's
actual performance.
Valuations on the balance sheet.
A. Four valuation bases to use in measuring an entity's performance and financial
position.
1.
Present value—represents the discounted future cash flows associated with a
particular financial statement item.
2.
Fair market value—represents the sales value in the output market.
3.
Replacement cost—represents the current prices paid in the input market.
4.
Original cost—represents the input price paid when originally purchased by
the company.
III. The principles of financial accounting measurement.
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A.
B.
Principle of objectivity.
1.
Financial accounting information must be verifiable and reliable. The value of
a transaction (and the assets and liabilities arising from that transaction) must
be objectively determined; individuals with conflicting incentives would agree
on the value of the transaction.
2.
Evaluation of present value, fair market value, and original cost on the
dimension of objectivity.
3.
Requirement for objective measures excludes items of value, such as accrued
goodwill, from an entity's financial statements.
Matching principle.
1.
Costs are matched against the benefits that result from them.
2.
The first step in applying the matching principle is deciding when to recognize
the benefit (i.e., revenue).
C. Principle of revenue recognition.
1.
Addresses the question of when to recognize revenue.
2.
Criteria for recognizing revenue.
a) The company must have completed a significant portion of the production
and sales effort.
b) The amount of revenue can be objectively measured.
c) The major portion of the costs has been incurred and the remaining costs
can be reasonably estimated.
d) The eventual collection of cash is reasonably assured.
D. Principle of consistency.
1.
Consistency refers to the use of the same accounting policies over time.
2.
GAAP encourages a company to use the same accounting policies to promote
comparability of a company's performance over time.
3.
Accounting methods can and do change from time to time.
IV. Two exceptions to the basic principles.
A.
Materiality.
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B.
1.
If the cost of providing financial information to investors exceeds the expected
benefit they would derive from the information, then the company may record
the event in the least costly method. In other words, an event is immaterial if
the way in which it is recorded would not affect investors' evaluation and
control decisions.
2.
Applying materiality requires a great deal of judgment.
Conservatism.
Conservatism states that, when in doubt, financial statements should understate
assets, overstate liabilities, accelerate the recognition of losses, and delay the
recognition of gains; when there is significant uncertainty about a transaction’s
value, the conservative alternative should be chosen.
V.
International perspective: Fundamental differences between US GAAP and IFRS
VI. Ethics in the real world.
VII. Internet research exercise.
LECTURE TIPS
1.
It is important to tie the principles and assumptions back into the objective of financial
accounting and to illustrate how the principles and assumptions affect accounting
procedures. A highly recommended approach is to have students evaluate different
companies using financial statements based on different assumptions and valuation bases.
2.
The use of illustrative cases may make it easier for students to understand the specific
principles and assumptions.
ANSWERS TO IN-TEXT DISCUSSION QUESTIONS
80.
Each of the various businesses within Fortune Brands are companies within a company
and have distinct needs to report separate measures of performance and financial position
for any number of management, credit, tax, and regulatory purposes. Most firms operate
with some degree of integration, so it may be difficult to account for transactions between
the various businesses and to account for corporate costs and assets common to all
members of the consolidated group.
80.
There is a trade-off between the timeliness of accounting information and its objectivity and
credibility. Certain accounting information becomes less reliable and more prone to error
because more arbitrary and subjective as the reporting period becomes shorter, and it has
not yet been subjected to independent verification. Timeliness is often more important than
precision to managers.
81.
Going concern is a fundamental assumption underlying our accounting model which uses
historical costs as a valuation basis and classifies assets and liabilities and current and
long-term. In making an evaluation of going concern status, auditors consider numerous
factors such as negative trends (recurring operating losses, capital deficiencies, adverse
financial ratios), other indicators of possible financial difficulties (default on loan
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agreements), and internal and external matters (labor difficulties, loss of a key customer or
supplier). Not being able to obtain needed financing negatively impacts the businesses'
prospects for remaining in business over the short term. Auditors are concerned with the
viability of a business as a going concern, because if a company were not expected to stay
in business beyond the current year, then liquidation values would be a more appropriate
valuation basis, and current and long-term classifications would be meaningless.
82.
Johnson & Johnson’s claim of a 5 percent increase in sales is legitimate because of the
stable dollar assumption.
83.
Financial statements are prepared on the stable dollar assumption, which assumes that the
purchasing power of the dollar remains constant across fiscal periods, ie, no inflation. If
inflation was significant to J.C. Penney, a user of the financial statements would want to
assess the degree to which the financial statements were in fact distorted because inflation
is ignored in the financial statements.
84.
An analyst attempting to compare companies using different currencies in their financial
statements would need to convert the financial statements of one of the two companies into
the currency of the other using the applicable exchange rates. This is easier said than
done.
85.
The $7.1 billion value reported as vehicles on Avis’s balance sheet would represent original
cost to Avis, ie, the input price paid when the vehicles were originally purchased. Present
value of the vehicles could be computed by projecting future cash flows from operation and
ultimately disposal of the vehicles, and discounting those cash flows back to a present
value using time value of money techniques. Fair market value of the vehicles would be
determined by what Avis could sell the vehicles for in the output market today.
Replacement cost would be the cost Avis would have to pay in today’s input market to
purchase the vehicles.
Original cost is useful because it is objectively measurable and verifiable. Present value
involves a great deal of estimation; in concept it does indicate the true economic value to
the firm of the vehicles. Fair market value and replacement cost both represent established
prices in the output and input markets, respectively, which would be obtainable from buyers
and sellers. Fair market value and replacement cost would be most useful if Avis planned
to sell off the fleet or replace it. However, neither possibility coincides with the planned use
by Avis of the vehicles.
85.
Because there was no market for these assets, there was no market value. Cost is
irrelevant. Management’s best estimate of the net realizable value of the assets would be
more meaningful than either zero or cost.
87.
The greatest dollar amount of NIKE’s assets consists of current assets – cash, short term
investments, receivables and inventory. Cash is valued at face, short term investments at
market, receivables at net realizable value, and inventory at the lower of cost or market.
Property, plant and equipment, intangible assets and goodwill are all valued at historical
cost (net of amortization or depreciation).
88.
Any attempt to value intellectual property rights would be inherently subjective. An
important principle of accounting measurement is the principle of objectivity, which requires
that for accounting information to be reliable, it must be verifiable (ie, determined, usually in
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an arm’s-length transaction, and backed by documentary evidence). Intellectual property
rights that are purchased are valued at cost (net of amortization) but those developed
internally do not appear on balance sheets.
89.
The proposed new standard would use uncertain estimates of future cash flows to estimate
fair value where observable market prices are not available. Such a standard has the
advantage of providing economic value information consistent with an entity’s expectations
of future use of the asset, but does involve complex judgments and gives imprecise results.
90.
Under US GAAP the principal of objectivity demands that property, plant and equipment be
recorded at historical cost. Fair market value is a subjective determination and is useful
information and has not been adopted by GAAP for incorporation into the financial
statements because of appraisal costs and concerns about manipulation of net income with
the effects of valuation changes. Because IFRS allows the use of fair market value in
certain situations for valuation for intangible assets and for property, plant and equipment,
one can infer that the principle of objectivity is less important under IFRS than it is under
US GAAP.
92.
The change had the effect of spreading revenue over several future years rather than all in
the first year when the contracts were signed, thereby reducing current income and
increasing future income. Spreading the revenue is a better example of the matching
process. Certainly the company will have costs in future years to service the contracts and
spreading the revenues forward to those future years provides for a better matching of the
cost of the efforts with the benefits.
93.
The cumulative effect of such an accounting change would be shown in the year of the
change as a separate line item in the income statement. Additionally, the change would be
described in footnotes to the financial statements and highlighted in the auditor’s report.
94.
A quantitative analysis of materiality is based solely on the size of the item in dollar terms
relative to some base. The SEC noted that many companies and auditors consider 5% of
income as a materiality threshold, i.e., items greater than that amount would affect the
judgment of a reasonable user of the financial statements. The SEC implored companies
and auditors to also consider the qualitative effect of an item, even if otherwise small. Such
qualitative effects include changes in earnings or other trends, compliance with loan
covenants or contractual agreements, unlawful acts, and so on.