Financial accounting 10th pratt peters chapter 03

Chapter 3: The Measurement Fundamentals of Financial Accounting Learning Objective Identify and describe the four basic assumptions of financial accounting Basic Assumptions of Financial Accounting • Basic assumptions are foundations of financial accounting measurements • The basic assumptions are: • • • • Economic entity Fiscal period Going concern Stable dollar 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, Comcast and NBC are presented as consolidated entities because of the ownership structure Fiscal Period • 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 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 Stable Dollar • 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 Concept Practice Concept Practice – cont b Justify the answer in terms of the four revenue recognition criteria The four criteria for recognizing revenue are (1) the company has completed a significant portion of the production and sales effort, (2) the amount of revenue can be objectively measured, (3) the title of goods has transferred to the buyer, and (4) cash collection is reasonably assured c Are there conditions under which the revenue could be recognized in a different month from the one chosen in (a)? Revenue could be recognized (1) during production, (2) at the completion of production, (3) at the point of delivery, or (4) when the cash is collected Since the production and sales effort was not really complete until McKey shipped the brackets on February 9, February appears to be the appropriate date to recognize the revenue d Why is the timing of revenue recognition important to McKey’s management? McKey's managers could be interested in the timing of revenue recognition due to incentives provided by contracts For example, the managers may be paid a bonus based upon accounting income Revenue recognition must portray a fair representation of the company’s financial activities to external users of the statements The Principle of Consistency • 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 Which one of the following is violated when a company recognized revenue upon the receipt of cash from a customer who has paid in advance for services? a Expense policy b Objectivity c Matching d Revenue recognition criteria Learning Objective List and explain the two major exceptions to the principles of financial accounting: materiality and conservatism Exceptions (Constraints) to the Basic Principles • These exceptions contradict the basic principles, in certain circumstances They are: • • Materiality Conservatism Materiality • Materiality • • • Only transactions with amounts large enough to make a difference are considered material (a reasonable investor would think it is important) 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 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 Expensing the cost of a pencil holder that cost $1.25 instead of capitalizing it as a plant asset and depreciating it over its estimated useful life of 10 years: a violates the economic entity assumption b violates GAAP since pencil holders are important assets c is justified because of materiality d is appropriate because of the stable dollar assumption Which one of the following statements best describes the concept of conservatism? a Profits should be accelerated in all cases b The measurement of an event is verifiable and reliable c The value of goods and services provided is recognized when earned d When uncertainty exists, understating assets, overstating liabilities, accelerating recognition of losses, and delaying recognition of gains is preferred Learning Objective Summarize the fundamental differences between U.S GAAP and IFRS Fundamental Differences – U.S GAAP and IFRS • IFRS is “principles-based” while U.S GAAP is “rules-based” • IFRS leaves more discretion to management • U.S GAAP generally does not allow the use of fair market values unless they can be objectively determined • IFRS allows adjustments to the balance sheet values for changes in market value International Perspective • Discretion given to management under IFRS demands management depict performance in a “true and fair” manner • Still some believe that the additional discretion available to management under IFRS can be used to manipulate reported earnings Wiley © 2017 .. .Chapter 3: The Measurement Fundamentals of Financial Accounting Learning Objective Identify and describe the four basic assumptions of financial accounting Basic Assumptions of Financial Accounting. .. that appear on the financial statements Principles of Financial Accounting Measurement • When transactions occur, we must decide when to recognize the transactions in the financial statements,... 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