Financial accounting 10th pratt peters chapter 03

Chapter 3:
The Measurement
Fundamentals
of Financial Accounting


Learning Objective 1

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 1


Concept Practice 1 – cont.


Learning Objective 2

Distinguish the markets in which companies
operate and the valuation bases used on the
balance sheet.


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


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.


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, short-term investments are

adjusted to their fair market value, or sales
price, at the end of the reporting period.


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.


Original (Historical) Cost as a Valuation
Base

•

Original 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.

•

Under IFRS, certain companies are allowed to value
property, plant, and equipment at fair market value.

•

“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)


Valuation
Bases
Used on
the
Balance
Sheet assets


Valuation
Bases
Used on
the
Balance
Sheet –
liabilities
& equity

Concept Practice 2


Learning Objective 3

Define the principle of objectivity and describe
how it determines the dollar values 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, and how to measure the transactions.

•

The principles of recognition and measurement are:

•
•
•
•

Objectivity
Matching

Revenue recognition
Consistency


The Principle of Objectivity
•

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.


Present Value and the Financial
Statements
•

Based on the principle of objectivity, present
value is only used when the future cash flows
associated with assets and liabilities are
predictable enough to allow for sufficient
objectivity (like a legal contract).


Market Value and the Financial

Statements
•

Market values are attractive to use for objective
values because they provide the best estimate of
present value. However, not all items are actively
traded and, therefore, may not have an objective
market value


Original Cost and the Financial
Statements
•

Prepaid expenses, land securities, property,
plant, and equipment and intangible assets are
valued at the cost originally acquired or net book
value. These values can be objectively verified
and are documented.