Chapter 3:
The Measurement Fundamentals
of Financial Accounting
1
Basic Assumptions
Basic assumptions are foundations of
financial accounting measurements
 The basic assumptions are
– Economic entity
– Fiscal period
– Going concern
– Stable dollar

2
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, General
Electric and NBC.

3
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.

4
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.

5
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.
6
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
7
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.

8
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.

9
Replacement 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.

10
Historical 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.
 “Cash equivalent price” is used to
calculate historical cost when cash is
not paid (as in the issue of a liability to
purchase the asset)

11
Principles of Financial Accounting
Measurement

When transactions occur, we must decide when to
recognize the transactions in the financial
statements, and how to measure the transactions.
 The principles of recognition and measurement
are:
– Objectivity
– Revenue recognition
– Matching
– Consistency
12
The 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 determined.

13
The Revenue
Recognition 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).
14
The 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.
15
The 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.
16
Exceptions (Constraints) to the
Basic Principles
These exceptions contradict the basic
principles, in certain circumstances.
 They are:
– Materiality
– Conservatism

17
Materiality
Materiality (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.

18
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.
19
International Perspective
Conservatism is pervasive in foreign
financial statements.
 In Japan and most of western Europe,
where creditors provide large amounts of
capital, companies prepare reports that
contain intentional understatement of
assets and overstatement of liabilities.
 In Switzerland, federal law encourages
management to set up “hidden reserves,”
through excessive depreciation or liability
write-ups, to permit income smoothing.

20
Brief Exercise 3-1
1. Reporting period ends on Saturday closest to Jan.
31.
2. Consolidated financials include subsidiaries.
3. Inventory valued at lower of cost or market.
4. Reclassifications made to conform with this year’s
presentation.
5. Revenues recognized when motion pictures
exhibited.
Brief Exercise 3-1(continued)
6. Management believes lawsuit will not have a
material impact on Company’s financial position.
7. Equipment depreciated over 20 years.
8. Intangible assets carried on B/S at cost.
9. Property and equipment recorded at cost.
10.Inflation rates have no effect on the company’s
financials.