Measurement Fundamentals BUS 210 Chapter 3
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Financial Accounting Fundamentals Valuation Input Market (purchase)-original, replacement Output Market (sell)-present, fair market Financial Statements: Original (Historic) Cost: Land, LT Invt Lower of Cost or Market: Inventory Net Realizable Value: net AR Net Book Value: PP&E, Intang. Face: Cash, Current liabilities Fair Market Value (sales price): ST Invt Present Value: LT NR & LTL IFRS v. US GAAP Principles based Rules based
Financial Accounting Fundamentals Assumptions Economic Entity (identified and measured) Fiscal Period (periodicity) Going Concern (life indefinite) Stable Dollar (across time) Measurement Principles Objectivity (Verifiable and documented) Revenue Recognition Expense Recognition Matching No More (costs & benefits) Consistency (methods same across time) Two Exceptions Materiality little to no effect on user decisions Conservatism -understate assets, overstate liabilities, accelerate losses, and delay gains (due to legal liability)
Conceptual Framework Overview of the Conceptual Framework First Level = Basic Objectives Second Level = Qualitative Characteristics and Elements Third Level = Recognition, Measurement, and Disclosure Concepts.
Conceptual Framework for Financial Reporting LO 4
Second Level: Fundamental Concepts Qualitative Characteristics of Accounting Information The FASB identified the qualitative characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.
Second Level: Fundamental Concepts Hierarchy of Accounting Qualities
Relevance Conceptual Framework for Financial Reporting LO 4
Second Level: Fundamental Concepts Fundamental Quality Relevance To be relevant, accounting information must be capable of making a difference in a decision.
Second Level: Fundamental Concepts Fundamental Quality Relevance Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future.
Second Level: Fundamental Concepts Fundamental Quality Relevance Relevant information also helps users confirm or correct prior expectations.
Second Level: Fundamental Concepts Fundamental Quality Relevance Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information.
Faithful Representation Illustration 2-7 Conceptual Framework for Financial Reporting LO 4
Second Level: Fundamental Concepts Fundamental Quality Faithful Representation Faithful representation means that the numbers and descriptions match what really existed or happened.
Second Level: Fundamental Concepts Fundamental Quality Faithful Representation Completeness means that all the information that is necessary for faithful representation is provided.
Second Level: Fundamental Concepts Fundamental Quality Faithful Representation Neutrality means that a company cannot select information to favor one set of interested parties over another.
Second Level: Fundamental Concepts Fundamental Quality Faithful Representation An information item that is free from error will be a more accurate (faithful) representation of a financial item.
Second Level: Fundamental Concepts Enhancing Qualities Information that is measured and reported in a similar manner for different companies is considered comparable.
Second Level: Fundamental Concepts Enhancing Qualities Verifiability occurs when independent measurers, using the same methods, obtain similar results.
Second Level: Fundamental Concepts Enhancing Qualities Timeliness means having information available to decision-makers before it loses its capacity to influence decisions.
Second Level: Fundamental Concepts Enhancing Qualities Understandability is the quality of information that lets reasonably informed users see its significance.
Second Level: Basic Elements Concepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise. Moment in Time Period of Time Assets Investment by owners Liabilities Distribution to owners Equity Comprehensive income Revenue Expenses Gains Losses
Second Level: Basic Elements Question According to the FASB conceptual framework, an entity s revenue may result from a. A decrease in an asset from primary operations. b. An increase in an asset from incidental transactions. c. An increase in a liability from incidental transactions. d. A decrease in a liability from primary operations.
Third Level: Recognition and Measurement The FASB sets forth most of these concepts in its Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. Conceptual Framework for Financial Reporting
Third Level: Basic Assumptions Economic Entity company keeps its activity separate from its owners and other businesses. Going Concern - company to last long enough to fulfill objectives and commitments. Monetary Unit - money is the common denominator. Periodicity - company can divide its economic activities into time periods.
Third Level: Basic Assumptions Illustration: Identify which basic assumption of accounting is best described in each item below. (a) The economic activities of KC Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes. Periodicity Monetary Unit Going Concern Economic Entity
Third Level: Basic Principles Measurement Principle The most commonly used measurements are based on historical cost and fair value. Issues: Historical cost provides a reliable benchmark for measuring historical trends. Fair value information may be more useful. Recently the FASB has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities. Reporting of fair value information is increasing.
Third Level: Basic Principles Revenue Recognition - requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Expense Recognition - Let the expense follow the revenues. Illustration 2-6 Expense Recognition
Third Level: Basic Principles Illustration: Assume the Boeing Corporation signs a contract to sell airplanes to Delta Air Lines for $100 million. To determine when to recognize revenue, use the five steps for revenue recognition shown at right.
Third Level: Basic Principles Full Disclosure providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Provided through: Financial Statements Notes to the Financial Statements Supplementary information
Third Level: Basic Principles Illustration: Identify which basic principle of accounting is best described in each item below. (a) KC Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater. Revenue Recognition Expense Recognition Full Disclosure Measurement
Third Level: Constraints Cost Constraint cost of providing information must be weighed against the benefits that can be derived from using it. Illustration: The following two situations represent applications of the cost constraint. (a) (b) Rafael Corporation discloses fair value information on its loans because it already gathers this information internally. Willis Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it.
Conceptual Framework for Financial Reporting Summary of the Structure
Cash Basis Accounting Primarily used by individuals and small businesses. Not permitted for revenue and expenses measurement and reporting under GAAP. Under cash basis accounting, revenues are recognized only in the period when cash is received. Under cash basis accounting, expenses are recognized only in the period when cash is disbursed. Cash basis accounting Income Statement reports the cash received as revenue and the cash expenses incurred.
Accrual Accounting Basic to financial reporting of corporations. Concerned with the timing of revenue and expense recognition. Purpose is to accurately measure revenues and expenses (and profits) for each accounting period. Accrual accounting s Income Statement attempts to match revenues earned and the expenses incurred, NOT cash flows. Accrual accounting s Statement of Cash Flows reports the cash inflows and outflows for the period.
Accrual Accounting Revenues Revenues are recognized and recorded when they are (1) earned and are (2) realized or realizable. Revenues are earned when the primary revenue generating activities are substantially completed (usually the point of delivery of goods or completion of services, i.e., title passes). Revenues are realized when cash is collected. Revenues are realizable when a viable and measurable claim to cash is acquired. A viable claim is one that is expected to be collected under normal terms of collection. The actual receipt of cash is not required for revenue to be recognized, and in many cases the receipt of cash does not trigger an immediate recognition of revenue. Hence, under accrual accounting, depending on when both conditions (earned & realized) have been met, it may be necessary to recognize revenues either before, at the time, or after cash is collected, i.e. accruals, unearned.
Revenue Recognition: Text 4 Steps v. Just Released 5 Steps 1. The company has completed a significant portion of the production and sales efforts. 2. The amount of revenue can be objectively measured. 3. The company has incurred the majority of costs, and remaining costs can be reasonably estimated, and 4. Cash collection is reasonably assured.
Matching Concepts Underlying the accrual accounting concept is the Matching concept. This concept holds that revenues recognized in a particular period should be accompanied by (or matched with) the recognition of expenses related to those revenues costs should follow the revenues. Some costs, such as cost of goods sold or cost of sales, have a direct relation to specific revenues and should be recognized as expenses in the same period as the revenues to which they relate. Other costs, such as rent, depreciation, and some salaries, may not be directly traceable to specific revenues of the period, but they relate indirectly to the period s revenue because they represent costs expired during the period in which revenues are recognized; hence they are an expense of the period. Some costs, such as research and development (R&D), have future expected benefits that cannot be determined objectively, so they are expensed in the period in which they are incurred. Implementing accrual accounting and the matching concept often requires adjusting entries at the end of the period to ensure that the books match all the appropriate revenues and expenses for the period.
Accruals and Deferrals An accrual asset or liability is created on the balance sheet any time revenue or expense is recognized (accrued) BEFORE the associated cash flow is received or paid. Examples: Accounts Receivable, Interest Receivable, Accounts Payable, Taxes Payable.[Expense now, Pay later. OR Receive later, Revenue now.] A deferral asset or liability is created on the balance sheet anytime cash is collected or paid BEFORE the associated expense or revenue is recognized (deferred). Examples: Inventories, Prepaid expenses, Equipment, Unearned revenues.
Accrual Balance Sheet Assets on the Balance Sheet include: Something that has future or potential value. Future expenses for which cash has already been paid. (Prepaid i.e., deferred Expenses) Past revenues for which cash has not been collected. (Accounts Receivable i.e., accrued revenues) Liabilities on the Balance Sheet include: Responsibilities or promises to others Past expenses for which cash has not been paid. (Accrued Expenses Payable) Future revenues for which cash has already been collected. (Deferred or Unearned Revenues)
Accrual Income Statement Reported revenues include: Revenues collected in a prior period deferred to the current period (reported previously on the balance sheet as a liability, Unearned Revenues) Revenues collected in the current period that were also earned currently. Revenues earned (and accrued) currently that will be collected in future periods (reported currently on the balance sheet as an asset, Accounts Receivable.
Accrual Income Statement Reported expenses include: The cost of goods or services consumed in the current period that were paid for in a prior period, but deferred to the current period (reported previously on the balance sheet as an asset; i.e., Inventories, Prepaid Expenses). The cost of goods or services consumed in the current period that were also paid for in the current period. The cost of goods or services consumed in the current period that will be paid for in future periods (reported on the current balance sheet as a liability; i.e., Accounts Payable).
Subjective Judgments Valuation Input Market (purchase)-original, replacement Output Market (sell)-present, fair market Financial Statements: Original (Historic) Cost: Land, LT Invt Lower of Cost or Market: Inventory Net Realizable Value: net AR Net Book Value: PP&E, Intang. Face: Cash, Current liabilities Fair Market Value (sales price): ST Invt Present Value: LT NR & LTL
Bottom Line.. Accrual accounting fails to serve its intended purpose of matching revenues and expenses on the income statement and reporting appropriate amounts for accruals and deferrals on the balance sheet unless those responsible (Managers, Accountants, & Auditors) are people of integrity.
ID3-7 Matching and mismatching Much has been written about accounting fraud and subsequent bankruptcy of WorldCom. The Baltimore Sun reported that the Fraud was brazen (and) easy to spot The scheme was not complicated: the company s financial officers recorded routine maintenance expenses totaling $3.9 billion as capital expenditures, which can be written off over decades rather than booked as immediate expenses. a. Explain how capitalizing an item, instead of expensing it, affects the financial statements. b. Which principle of accounting is being violated? Are other principles involved? Discuss.
P3-12 Revenue recognition and net income a. Assuming that Hydra recognizes revenue when the toasters are produced, how much revenue should be recognized in each of the 3 years? b. Assuming Hydra recognizes revenue at delivery, how much revenue should be recognized in each of the 3 years? c. Calculate net income for the 3 periods under each of the two assumptions above. d. If Hydra s management is paid an income-based bonus, which of the two assumptions would be preferred? Hydra sells appliances to Seasons Department Store. A recent order requires Hydra to manufacture and deliver 500 toasters at a price of $100 per unit. Hydra s manufacturing costs are approximately $40 per unit. The following schedule summarizes the production and delivery record of Hydra: Year 1 2 3 Total Toasters produced 200 200 100 500 Costs incurred $8,000 $8,000 $4,000 $20,000 Toasters delivered 150 200 150 500 Cash received $10,000 $15,000 $20,000 $45,000
P3-12
E3-5 Matching and Revenue recognition Cascade Enterprises ordered 4,000 brackets from McKay and Company on 12.1.2011, for a contract price of $40,000. McKay completed manufacturing the brackets on 1.17.12 and delivered them to Cascade on 2.9.12. McKay received a check for $40,000 from Cascade on 3.14.12. a. Assume that McKay and Company prepare monthly income statements. In which month should McKay recognize the $40,000 revenue from the sale? b. Justify your answer in (a.) in terms of the 4 criteria of revenue recognition.
E3-5 Matching and Revenue recognition Cascade Enterprises ordered 4,000 brackets from McKay and Company on 12.1.2011, for a contract price of $40,000. McKay completed manufacturing the brackets on 1.17.12 and delivered them to Cascade on 2.9.12. McKay received a check for $40,000 from Cascade on 3.14.12. c. Are their conditions under which the revenue could be recognized in a different month than the month you chose? d. Provide several reasons McKay s management might be interested in the timing of the recognition of revenue.
Materiality Q: Have you ever wondered why companies Sometimes do not restate for the prior period when a major event occurs, such as an acquisition, that makes current and prior years non-comparable? Can avoid recording losses on the income statement Can capitalize (record as an asset) normal operating expenses Fail to disclose one-time gains or losses as separate line items on the income statement In short ignore the normal accounting conventions. Q: How can you convince your independent auditor to allow your company to circumvent normal accounting conventions? Materiality exception the impact of recording a transaction in a more expedient (although technically improper) way has no significant impact on the investor, normal accounting conventions could be ignored. Thus, prior-period financial statements need not be restated if the change is deemed immaterial; and normal operating expenses could be capitalized if the amount is insignificant. Adapted from: Center for Research and Financial Analysis, Inc.
Materiality Exception Due to the subjectivity in assessing materiality, over time certain quantitative thresholds (rules of thumb) have been used. Some use a 5% overstatement of net income as a threshold for materiality. Securities and Exchange Commission (SEC) staff point out that exclusive reliance on any percentage or numerical threshold has no basis in accounting literature. In SFAC No. 2 the Financial Accounting Standards Board (FASB) states the essence of materiality is: The omission or misstatement of an item in a financial report is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item. The Supreme Court has held that a fact is material if there is: a substantial likelihood that the fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.
Interpreting Materiality Rather than relying on a numerical threshold, materiality judgments should be based on all the facts, qualitative and quantitative. The SEC s SAB No. 99 provides certain valuable insights to help investors make material judgments. Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are whether the misstatement: Arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate Masks a change in earnings or other trends Hides a failure to meet analysts consensus expectations for the enterprise Changes a loss into income or visa versa Concerns a segment or other portion of the registrant s business that has been identified as playing a significant role in the registrant s operations or profitability Affects the registrant s compliance with regulatory requirements Affects the registrant s compliance with loan covenants or other contractual requirements Has the effect of increasing management s compensation for example, by satisfying requirements for the award of a bonus or other forms of incentive compensation whether the misstatement involves concealment of an unlawful transaction.
E3-8 The concept of materiality All large U.S. companies have policies in which all expenditures under a certain dollar amount are expensed. Many of these expenditures are for assets, items that are useful to a company beyond the period in which they were purchased. a. Explain the proper accounting treatment for expenditures for items that are expected to generate benefits in the future. b. Explain why it might make economic sense to expense some of these items. Upon what exception to the principles of financial accounting would such a decision be based?
Conservatism Conservatism in measurement and reporting understate assets, overstate liabilities, accelerate losses, and delay gains (due to legal liability)
ID3-10 Income management and conservatism Whitney Tilson, a noted analyst, warns investors in an article in The Motley Fool that more than any other type of company, financial companies have immense discretion regarding what earnings to report. The key is the rate of loan losses that they expect to experience, which must be estimated at the end of every period. By changing the estimate, which in turn changes one of the largest expenses on their income statement, financial companies can manage net income. Tilson specifically cites Farmer Mac, the agency created by the federal government to provide funds in the agricultural lending market, which many analysts believe smooths it earnings across time by simply changing its estimate of loss rates. a. What does it mean to smooth earnings across time? How might a financial company practice this strategy, and why might it engage in this activity? b. Earnings smoothing has also been associated with conservatism. Why?