Principles Of Financial Accounting Mcgraw Hill Answers

[Heron Mathis]

Now that the various elements of financial statements have been identified, we discuss when they should be recognized (recorded) and how they should be measured. SFAC 5 addresses these issues. Recognitionprocess of admitting information into the basic financial statements. refers to the process of admitting information into the basic financial statements. Measurementprocess of associating numerical amounts to the elements. is the process of associating numerical amounts to the elements. For example, a revenue was previously defined as an inflow of assets from selling a good or providing a service. But, when should the revenue event be recorded, and at what amount?

According to SFAC 5, an item should be recognized in the basic financial statements when it meets the following four criteria, subject to a cost effectiveness constraint and materiality threshold:

The question of measurement involves two choices: (1) the choice of a unit of measurement, and (2) the choice of an attribute to be measured. SFAC 5 essentially confirmed existing practice in both of these areas. The monetary unit or measurement scale used in financial statements is nominal units of money without any adjustment for changes in purchasing power. In addition, the board acknowledged that different attributes such as historical cost, net realizable value, and present value of future cash flows are presently used to measure different financial statement elements, and that they expect that practice to continue. For example, property, plant, and equipment are measured at historical cost; accounts receivable are measured at their net realizable value; and most long-term liabilities, such as bonds, are measured at the present value of future cash payments.

Present value measurements have long been associated with accounting valuation. However, because of its increased prominence, present value is the focus of a recent FASB concept statement that provides a framework for using future cash flows as the basis for accounting measurement and also asserts that the objective in valuing an asset or liability using present value is to approximate the fair value of that asset or liability.38 We explore this objective in more depth in Chapter 6.

Answers to the recognition and measurement questions are imbedded in generally accepted accounting principles. SFAC 5 confirmed some of the more important of these principles used in present practice. GAAP consist of broad principles and specific standards. The accrual accounting model is an example of a broad principle. Before addressing additional key broad principles, we look at some important assumptions that underlie those fundamental principles.

Economic Entity Assumption. An essential assumption is that all economic events can be identified with a particular economic entity. Investors desire information about an economic entity that corresponds to their ownership interest. For example, if you were considering buying some ownership stock in FedEx, you would want information on the various operating units that constitute FedEx. You would need information not only about their United States operations but also about their European and other international operations. Also, you would not want the information about FedEx combined with that of United Parcel Service (UPS), another air freight company. These would be two separate economic entities. The financial information for the various companies (subsidiaries) in which FedEx owns a controlling interest (greater than 50% ownership of voting stock) should be combined with that of FedEx (the parent). The parent and its subsidiaries are separate legal entities but one accounting entity.

Another key aspect of this assumption is the distinction between the economic activities of owners and those of the company. For example, the economic activities of a sole proprietorship, Uncle Jim’s Restaurant, should be separated from the activities of its owner, Uncle Jim. Uncle Jim’s personal residence, for instance, is not an asset of the business.

Going Concern Assumption. Another necessary assumption is that, in the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely. Accountants realize that the going concern assumptionin the absence of information to the contrary, it is anticipated that a business entity will continue to operate indefinitely. does not always hold since there certainly are many business failures. However, companies are begun with the hope of a long life, and many achieve that goal.

This assumption is critical to many broad and specific accounting principles. For example, the assumption provides justification for measuring many assets based on their historical costs. If it were known that an enterprise was going to cease operations in the near future, assets and liabilities would not be measured at their historical costs but at their current liquidation values. Similarly, depreciation of a building over an estimated life of 40 years presumes the business will operate that long.

Periodicity Assumption. The periodicity assumptionallows the life of a company to be divided into artificial time periods to provide timely information. relates to the qualitative characteristic of timeliness. External users need periodic information to make decisions. This need for periodic information requires that the economic life of an enterprise (presumed to be indefinite) be divided into artificial time periods for financial reporting. Corporations whose securities are publicly traded are required to provide financial information to the SEC on a quarterly and annual basis.39 Financial statements often are prepared on a monthly basis for banks and others that might need more timely information.

For many companies, the annual time period (the fiscal year) used to report to external users is the calendar year. However, other companies have chosen a fiscal yearthe annual time period used to report to external users. that does not correspond to the calendar year. The accounting profession and the Securities and Exchange Commission advocate that companies adopt a fiscal year that corresponds to their natural business year. A natural business year is the 12-month period that ends when the business activities of a company reach their lowest point in the annual cycle. For example, many retailers, Wal-Mart for example, have adopted a fiscal year ending on January 31. Business activity in January generally is quite slow following the very busy Christmas period. We can see from the FedEx financial statements that the company’s fiscal year ends on May 31. The Campbell Soup Company’s fiscal year ends in July; Clorox’s in June; and Monsanto’s in August.

Monetary Unit Assumption. Recall that to measure financial statement elements, a unit or scale of measurement must be chosen. Information would be difficult to use if, for example, assets were listed as “three machines, two trucks, and a building.” A common denominator is needed to measure all elements. The dollar in the United States is the most appropriate common denominator to express information about financial statement elements and changes in those elements.

One problem with this assumption is that the monetary unit is presumed to be stable over time. That is, the value of the dollar, in terms of its ability to purchase certain goods and services, is constant over time. This obviously does not strictly hold. The U.S. economy has experienced periods of rapidly changing prices. To the extent that prices are unstable, and those machines, trucks and building were purchased at different times, the monetary unit used to measure them is not the same. The effect of changing prices on financial information generally is discussed elsewhere in your accounting curriculum, often in an advanced accounting course.

There are four important broad accounting principles that provide significant guidance for accounting practice: (1) the historical cost principle, (2) the realization principle (also known as the revenue recognition principle), (3) the matching principle, and (4) the full-disclosure principle. These principles deal with the critical issues of recognition and measurement. The accrual accounting model is embodied in each of the principles.

Historical Cost Principle. The FASB recognized in SFAC 5 that elements in financial statements currently are measured by different attributes. In general, however, GAAP measure assets and liabilities based on their original transaction value, that is, their historical costs.original transaction value. For an asset, this is the fair value of what is given in exchange (usually cash) for the asset at its initial acquisition. For liabilities, it is the current cash equivalent received in exchange for assuming the liability. For example, if a company borrowed $1 million cash and signed an interest-bearing note promising to repay the cash in the future, the liability would be valued at $1 million, the cash received in exchange.40

Why base measurement on historical costs? After all, the current value of a company’s manufacturing plant might seem more relevant than its original cost. First, historical cost provides important cash flow information as it represents the cash or cash equivalent paid for an asset or received in exchange for the assumption of a liability. Second, because historical cost valuation is the result of an exchange transaction between two independent parties, the agreed on exchange value is objective and highly verifiable. Alternatives such as measuring an asset at its current market value involve estimating a selling price. An example given earlier in the chapter concerned the valuation of a parcel of land. Appraisers could easily differ in their assessment of current market value.

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