Recognition and Measurements Concepts

These lectures cover CPA questions that cover historical cost, revenue recognition, matching principle, expense recognition, fair value and full disclosures.

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Basic Principles of Accounting

We generally use four basic principles of accounting to record and report transactions: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure. We look at each in turn.

Measurement Principle

We presently have a “mixed-attribute” system that permits the use of various measurement bases. The most commonly used measurements are based on historical cost and fair value. Here, we discuss each.

Historical Cost.

GAAP requires that companies account for and report many assets and liabilities on the basis of acquisition price. This is often referred to as the historical cost principle. Historical cost has an important advantage over other valuations: It is generally thought to be verifiable.To illustrate this advantage, consider the problems if companies select current selling price instead. Companies might have difficulty establishing a value for unsold items. Every member of the accounting department might value the assets differently. Further, how often would it be necessary to establish sales value? All companies close their accounts at least annually. But some compute their net income every month. Those companies would have to place a sales value on every asset each time they wished to determine income. Critics raise similar objections against current cost (replacement cost, present value of future cash flows) and any other basis of valuation except historical cost.

What about liabilities? Do companies account for them on a cost basis? Yes, they do. Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for assets (or services), for an agreed-upon price. This price, established by the exchange transaction, is the “cost” of the liability.A company uses this amount to record the liability in the accounts and report it in financial statements. Thus, many users prefer historical cost because it provides them with a verifiable benchmark for measuring historical trends.

Fair Value.

Fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is therefore a market-based measure.  Recently, GAAP has increasingly called for use of fair value measurements in the financial statements. This is often referred to as the fair value principle. Fair value information may be more useful than historical cost for certain types of assets and liabilities and in certain industries. For example, companies report many financial instruments, including derivatives, at fair value. Certain industries, such as brokerage houses and mutual funds, prepare their basic financial statements on a fair value basis.At initial acquisition, historical cost equals fair value. In subsequent periods, as market and economic conditions change, historical cost and fair value often diverge. Thus, fair value measures or estimates often provide more relevant information about the expected future cash flows related to the asset or liability. For example, when long-lived assets decline in value, a fair value measure determines any impairment loss. In this situation, the FASB believes that fair value information is more relevant to users than historical cost. Fair value measurement, it is argued, provides better insight into the value of a company’s assets and liabilities (its financial position) and a better basis for assessing future cash flow prospects.

Recently, the Board has taken the additional step of giving companies the option to use fair value (referred to as the fair value option) as the basis for measurement of financial assets and financial liabilities.  The Board considers fair value more relevant than historical cost because it reflects the current cash equivalent value of financial instruments. As a result, companies now have the option to record fair value in their accounts for most financial instruments, including such items as receivables and debt securities.

Use of fair value in financial reporting is increasing. However, measurement based on fair value introduces increased subjectivity into accounting reports when fair value information is not readily available. To increase consistency and comparability in fair value measures, the FASB established a fair value hierarchy that provides insight into the priority of valuation techniques to use to determine fair value.

Revenue Recognition Principle

When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company satisfies this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.

Expense Recognition Principle

As indicated in the discussion of financial statement elements, expenses are defined as outflows or other “using up” of assets or incurring of liabilities (or a combination of both) during a period as a result of delivering or producing goods and/or performing services. It follows then that recognition of expenses is related to net changes in assets and earning revenues. In practice, the approach for recognizing expenses is, “Let the expense follow the revenues.” This approach is the expense recognition principle.

To illustrate, companies recognize expenses not when they pay wages or make a product, but when the work (service) or the product actually contributes to revenue. Thus, companies tie expense recognition to revenue recognition. That is, by matching efforts (expenses) with accomplishment (revenues), the expense recognition principle is implemented in accordance with the definition of expense (outflows or other using up of assets or incurring of liabilities).

Full Disclosure Principle

In deciding what information to report, companies follow the general practice of providing information that is of sufficient importance to influence the judgment and decisions of an informed user. Often referred to as the full disclosure principle, it recognizes that the nature and amount of information included in financial reports reflects a series of judgmental trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2) sufficient condensation to make the information understandable, keeping in mind costs of preparing and using it.

Disclosure is not a substitute for proper accounting. As a former chief accountant of the SEC noted, “Good disclosure does not cure bad accounting any more than an adjective or adverb can be used without, or in place of, a noun or verb.” Thus, for example, cash-basis accounting for cost of goods sold is misleading even if a company discloses accrual-basis amounts in the notes to the financial statements.

Users find information about financial position, income, cash flows, and investments in one of three places: (1) within the main body of financial statements, (2) in the notes to those statements, or (3) as supplementary information.

The financial statements are the balance sheet, income statement, statement of cash flows, and statement of stockholders’ equity. They are a structured means of communicating financial information. To be recognized in the main body of financial statements, an item should meet the definition of a basic element, be measurable with sufficient certainty, and be relevant and reliable

The notes to financial statements generally amplify or explain the items presented in the main body of the statements. If the main body of the financial statements gives an incomplete picture of the performance and position of the company, the notes should provide the additional information needed. Information in the notes does not have to be quantifiable, nor does it need to qualify as an element. Notes can be partially or totally narrative. Examples of notes include descriptions of the accounting policies and methods used in measuring the elements reported in the statements, explanations of uncertainties and contingencies, and statistics and details too voluminous for inclusion in the statements. The notes can be essential to understanding the company’s performance and position.

Supplementary information may include details or amounts that present a different perspective from that adopted in the financial statements. It may be quantifiable information that is high in relevance but low in faithful representation. For example, oil and gas companies typically provide information on proven reserves as well as the related discounted cash flows.

Supplementary information may also include management’s explanation of the financial information and its discussion of the significance of that information. For example, many business combinations have produced financing arrangements that demand new accounting and reporting practices and principles. In each of these situations, the same problem must be faced: making sure the company presents enough information to ensure that the reasonably prudent investor will not be misled.