How does Scarcity affect Economic Decision Making

how value judgement influence economic decision making and policy and how does opportunity cost affect economic decision making
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Economic 2 Decision Making ood fortune has come your way. After several weeks of interviewing, G you have received job offers from three firms. The offers differ greatly, which leaves you quite confused. You have made this list of the offers: 1. Large national firm, 12 per hour starting wage, life insurance and dental benefits paid by the company, a two-week paid vacation each year, and potential for rapid advancement. 2. Small local firm, 20 per hour starting wage, life insurance and dental benefits available but you must pay the premiums, a two- week paid vacation each year, share options and pension plan benefits, and potential for advancement. 3. Regional firm, 15 per hour starting wage, full life insurance and dental benefits, one-week paid vacation, good pension plan, and moderate advancement potential. Will you consider the short run or the long run for this decision? Which offer provides you with the most today and which one the most over the next five years? What is the real economic value of the benefits? Aside from the monetary considerations, do you like the work you will perform in each position and the people with whom you will work? How do you organize your thoughts to make this decision? Regardless of the form of organization or the business activity, success in the world of business—sometimes even survival—depends on making wise economic decisions. A key ingredient is an under- standing of the decision-making process itself. Because economic decision making relies heavily on accounting information, it is crucial for that information to be useful to economic decision makers.Life is a never-ending sequence of decisions, some very complex and others relatively simple. Because we cannot know the future, we strive to reduce uncertainty in any decision by collecting as much information as possible. We designed this chapter to help you learn a logical decision-making process.  LEARNING OBJECTIVES After completing your work on this chapter, you should be able to do the following: 1. Explain the concepts of extrinsic and intrinsic rewards, sacrifices, and opportunity costs as they pertain to decision situations. 2. Describe the two types of economic decision makers and explain the basic differences between management accounting and financial accounting. 3. List the three questions all economic decision makers attempt to answer and explain why these questions are so important. 4. Describe the importance of cash as a measure of business success or failure. 5. Define accounting information and distinguish it from accounting data. 6. Describe the qualitative characteristics of useful accounting information and apply them in decision-making situations. 7. Explain the difference between reality and the measurement of reality. 8. Apply the criteria for revenue and expense recognition under the cash basis of accounting to determine periodic net income. 9. Apply the criteria for revenue and expense recognition under the accrual basis of accounting to determine periodic net income. WHAT IS DECISION MAKING? Decision making is the process of identifying alternative courses of action and select- ing an appropriate alternative in a given decision situation. This definition pre- sents two important parts: 1. Identifying alternative courses of action means that an ideal solution may not exist or might not be identifiable. 2. Selecting an appropriate alternative implies that there may be a number of appropriate alternatives and that inappropriate alternatives are to be evaluated and rejected. Thus, judgment is fundamental to decision making. Choice is implicit in our definition of decision making. We may not like the alter- natives available to us, but we are seldom left without choices. Rewards and Sacrifices: The Trade-off In general, the aim of all decisions is to obtain some type of reward, either eco- nomic or personal. Reward requires sacrifice. When you made the decision to attend college or university, for example, you certainly desired a reward. What was the sacrifice? Chapter 2 Economic Decision Making 33Discussion Questions 2–1. What reward or rewards do you hope to obtain by attending college or university? 2–2. What sacrifices are you personally making to attend college or university ? Think of some things you cannot do because you are attending college. Some sacrifices cannot be measured in dollars (such as loss of sleep, lack of home-cooked meals, and loss of leisure time). Some, however, can be measured. Suppose that instead of attending college you could work full time and earn 15,000 a year. Attending college, therefore, costs you that 15,000, in addition to what you pay for tuition and books. We call the 15,000 an opportunity cost of making the decision to opportunity cost The attend college. An opportunity cost is the reward we forego because we choose a benefit or benefits forgone particular alternative instead of another. Most decisions include opportunity costs. by not selecting a particular Decision makers want the reward or benefit from a decision to be greater than alternative. Once an alternative the sacrifice or cost required to attain it (see Exhibit 2–1). Examining the relation- is selected in a decision ship between rewards and sacrifices is known as cost/benefit analysis. In a condi- situation, the benefits of all tion of absolute certainty, in which the outcome of a decision is known without rejected alternatives become doubt, cost/benefit analysis provides a certain outcome. Unfortunately, absolute part of the opportunity cost of certainty rarely, if ever, exists. the alternative selected. In examples that accountants use to describe the trade-off between rewards cost/benefit analysis and sacrifices, money is usually the reward. Money is an extrinsic reward, meaning Deals with the trade-off that it comes from outside ourselves and is a tangible object we can acquire. An between the rewards of intrinsic reward is one that comes from inside ourselves. When you accomplish a selecting a given alternative difficult task, the intrinsic reward comes from the sense of satisfaction you feel. An and the sacrifices required old adage says, “The best things in life are free.” Not so Anything worth having to obtain those rewards. requires sacrifice. Exhibit 2–1 Cost versus Benefit Cost Benefit Discussion Questions 2–3. What is the one thing you desire most from life? What sacrifices must you make to obtain it? 2–4. What sacrifice does a business owner make when purchasing machinery for the production plant? 2–5. What benefit does the owner derive from the sacrifice to purchase the machinery? 34 Chapter 2 Economic Decision MakingECONOMIC DECISION MAKING internal decision makers Economic decision making, in this book, refers to the process of making business deci- Economic decision makers sions involving money. All economic decisions of any consequence require the use within a company who make of some sort of accounting information, often in the form of financial reports. decisions for the company. They Anyone using accounting information to make economic decisions must under- have access to much or all of stand the business and economic environment in which accounting information is the accounting information generated, and they must also be willing to devote the necessary time and energy generated within the company. to make sense of the accounting reports. external decision makers Economic decision makers are either internal or external. Internal decision Economic decision makers makers are individuals within a company who make decisions on behalf of the outside a company who make company, while external decision makers are individuals or organizations outside decisions about the company. a company who make decisions that affect the company. Exhibit 2-2 illustrates The accounting information some decisions made by internal and external decision makers. they use to make those decisions is limited to what the company provides to them. EXTERNAL DECISION MAKERS Exhibit 2–2 Bankers External vs. Internal INTERNAL Decision Makers Loan DECISION MAKERS Marketing Customers Sales Campaigns Make Invoice Decisions Make Accounting Decisions Investors Financial Information About for a Firm the Shares Production What to Produce Firm Vendors Personnel Purchase Who to Hire Order Internal Decision Makers Internal decision makers decide whether the company should sell a particular product, whether it should enter a certain market, and whether it should hire or fire employees. Note that in all these matters, the responsible internal decision maker makes the decision not for himself or herself, but rather for the company. Depending on their position within the company, internal decision makers may have access to much, or even all, of the company’s financial information. They do not have complete information, however, because all decisions relate to the future and always involve unknowns. External Decision Makers External decision makers make decisions about a company. External decision mak- ers decide whether to invest in the company, whether to sell to or buy from the company, and whether to lend money to the company. Chapter 2 Economic Decision Making 35Unlike internal decision makers, external decision makers have limited finan- cial information on which to base their decisions about the company. In fact, they have only the information the company gives them—which in most cases is not all the information the company possesses. Discussion Questions 2–6. Identify a particular company (large or small). Who do you think are considered internal and external economic decision makers of the company? 2–7. For what reasons do you think a company would withhold certain financial information from external parties? 2–8. Is it ethical for a company to limit the information available to internal decision makers? External decision makers? The decisions made by internal and external decision makers are similar in some ways, but so different in other ways that the accounting profession devel- oped two separate branches of accounting to meet the needs of the two categories management accounting of users. Management accounting is not constrained by GAAP and generates The branch of accounting information for use by internal decision makers, whereas financial accounting is developed to meet the constrained by GAAP and generates information for use by external parties. informational needs of internal decision makers. What All Economic Decision Makers Want to Know financial accounting The branch of accounting Although internal and external parties face different decision situations, both developed to meet the attempt to predict the future, as do all decision makers. Specifically, all economic informational needs of decision makers attempt to predict future cash flow—the movement of cash in and external decision makers. out of a company. So one of the major objectives of financial reporting is to provide cash flow The movement of helpful information to those trying to predict cash flows. cash in and out of a company. The difference between cash inflows and cash outflows is net cash flow. Positive net cash flow indicates that the amount of cash flowing into the company net cash flow The difference exceeds the amount flowing out of the company during a particular period. For between cash inflows and cash outflows; it can be either example, a company that collects 1,000,000 during a period when it pays out positive or negative. 950,000 has a positive cash flow of 50,000. Negative net cash flow indicates that the amount of cash flowing out of the company exceeds the amount flowing into the company during a particular period (see Exhibit 2–3). Exhibit 2–3 Cash Flow Cash inflow  Cash outflow  Positive net cash flow 1,000,000  950,000  50,000 Cash inflow  Cash outflow  Negative net cash flow 500,000  575,000  75,000 All economic decisions involve attempts to predict the future of cash flows by searching for the answers to the following three questions: 36 Chapter 2 Economic Decision Making1. Will I be paid? This question refers to the uncertainty of cash flows. 2. When will I be paid? This question refers to the timing of cash flows. 3. How much will I be paid? This question refers to the amounts of cash flows. The answer to each question contains two parts: return on investment and return of investment. Return on investment consists of the earnings and profits an investment returns to the investor. Return of investment is the ultimate return of the principal invested. Exhibit 2–4 shows the conceptual link between the three major questions posed by economic decision makers and the resulting cash flows using the following example. Assume you wish to invest in a 1,000 term deposit at your bank, which will earn 10 percent interest per year, payable every three months, over the course of two years. If you invest in this term deposit, you must hold it for two years, after which the bank will return your 1,000. Exhibit 2–4 Three Big Questions for Economic Decision Makers Cash Outcome Questions Concepts Return on Investment Return of Investment 1. Will I be paid? Uncertainty Interest Term deposit maturity 2. When will I be paid? Timing Quarterly 2 years 3. How much will I be paid? Amount 25 per quarter 1,000 Total of 200 Before you make this economic decision, you must attempt to answer the three questions: 1. Will you be paid? Because it is impossible to know the future, making an economic decision always involves risk. However, assuming the economy does not collapse and the bank stays in business, you will be paid both your return on investment and your return of investment. 2. When will you be paid? You will receive an interest payment every three months for two years (return on investment), and then you will receive your initial 1,000 investment back (return of investment). 3. How much will you be paid? The return on your investment is the interest you receive quarterly of 25 (1,000  10 percent  3/12), and the return of your investment is the 1,000 the bank gives you back. The total received in interest in two years is 200 (8  25). Initial Investment 1,000 Return on Investment 200 Return of Investment 1,000 Total Return 1,200 Profit on Investment 200 We can answer these questions easily for the insured term deposit. In the vast major- ity of economic decision situations, the answers to the three questions we asked are much less certain. We will show you how to use accounting information to answer them in various economic decision situations throughout this text. Chapter 2 Economic Decision Making 37Discussion Questions 2–9. Assume that you are a lender with three customers who wish to borrow 10,000. You can lend to only one of them. What information would you require each of them to present for you to answer the three questions? How would you make your decision? Cash Is the “Ball” of Business If business were any game such as baseball, football, or soccer, then cash would be the ball. To be successful, the players must keep their eye on the ball. Because the business game is so complex, businesspeople easily become distracted and lose sight of (the ball) cash. Various measures of performance such as gross profit, net income, net worth, and equity help those in business to make economic decisions. These are important measures of financial performance, but they are not cash Never allow yourself to become so focused on any of them that you lose sight of cash, because when a company runs out of cash, it dies. Only cash pays the bills that keeps the company in business. The secret to becoming a street-smart user of accounting information is learning to balance the complexity of business with the simple rule of keeping your eye on cash flow. ACCOUNTING INFORMATION A company or a person generates accounting data with every business transaction. You generate a number of transactions each month when you pay your rent, buy groceries, make car payments, lend money to a friend, and so on. In fact, the vol- ume of business accounting data can be staggering. Data versus Information accounting information Accounting data and accounting information are not interchangeable terms. Data Raw data concerning are the raw results of transactions: data become information only when they are transactions that have been put into some useful form. Consider this example: transformed into financial Carol Brown, vice president of sales for Balloo Industries, noticed that the numbers that can be used by recent gasoline expense for the sales staff’s company cars was extremely high and economic decision makers. she suspected that salespersons were using the company cars for personal trips. information Data that Knowing that sales personnel were required to keep detailed odometer records, have been transformed so that she notified Jack Parsons, the sales supervisor, of her concerns. He agreed to pre- they are useful in the decision- pare a report to provide her with the necessary information to determine if the making process. expense was proper. The report compiled by Mr. Parsons consisted of five columns of data: 1. salesperson’s name; 2. make and model of that salesperson’s company car; 3. date the car was issued to the salesperson; 4. odometer reading on the date of issue; and 5. odometer reading at time of most recent maintenance. 38 Chapter 2 Economic Decision MakingMs. Brown quickly concluded that it contained little useful information. She told Parsons that she was trying to determine if any members of the sales force were using company cars for personal activities. Mr. Parsons retreated to his office to try again. In his second attempt, Parsons included the previous five columns plus four additional columns: 6. sales region covered; 7. how long the salesperson had been with the company; 8. total sales generated by the salesperson this year; and 9. current odometer reading of the vehicle. Was Ms. Brown pleased with the second version? No Mr. Parsons had pro- vided additional data, but no additional information. Discussion Question 2–10. Evaluate the usefulness to Ms. Brown of each column (1–9) of Parsons’ data. What information could Parsons have provided Ms. Brown to help her make a determination? Clearly, the correct data items must be gathered and converted into useful infor- mation before they are of any help to economic decision makers. Suppose you con- sider investing in shares of Dofasco Inc., the steel producer. You call your broker and she tells you the shares are currently selling at 30 per share. Do you want to invest? Although your broker has given you a datum (singular form of data), this datum provides insufficient information upon which to base a buying decision. You need to know something about the company’s current and historic earnings, the share price behaviour over the past year, the steel industry’s prospects, and so on. That is why brokerage firms such as RBC Dominion Securities, Scotia Capital, and TD Securities have research departments that extract such data and synthesize them into useful information for their clients. Useful Accounting Information The user of accounting information has the obligation to understand the business and be willing to study the information. The information provider has an obliga- tion to present it in such a way that economic decision makers can make sense of it. As business and economic activities have become more complex, however, the accounting profession has responded with increasingly complex rules, many of which are difficult for nonaccountants to comprehend. There are certain charac- teristics that accounting information must possess to be considered useful for deci- sion making. If the accounting profession does not provide what the information users need or does not prepare it in a way that makes sense, users must demand a change. Users and preparers must be mindful of the benefits provided by infor- mation, and the costs incurred to secure it (the cost/benefit analysis), and of its ulti- materiality Something that mate ability to make a difference in the decision (the materiality test). will influence the judgment of Two parties decide what accounting information is useful and what is not. One a reasonable person. is the users and the second is the accounting profession through the CICA. The CICA focuses on the qualitative characteristics of useful accounting information— Chapter 2 Economic Decision Making 39those qualities it must possess to be useful, whether it is financial or management accounting information. QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION The two primary qualities that distinguish useful accounting information are relevance One of the two relevance and reliability. If either of these qualities is missing, accounting infor- primary qualitative character- mation will not be useful. istics of useful accounting information. It means the infor- mation must have a bearing on Relevance a particular decision situation. To be considered relevant, accounting information must have a bearing on the par- reliability One of the two ticular decision situation. In other words, does it make a difference to decision primary qualitative characteristics makers? The accuracy of the information is not important if the content does not of useful accounting informa- matter to the decision being made. tion. It means the information Relevant accounting information possesses at least two characteristics: must be reasonably accurate. • Timeliness. If information providers delay making information available timeliness A primary char- until every number is perfectly accurate, it may be too late to be of any value. acteristic of relevance. To be This does not mean that accuracy does not matter. But if accounting useful, accounting information must be provided in time to information is not timely, it has no value. influence a particular decision. Timeliness alone, however, is not enough. To be relevant, accounting informa- predictive value A primary tion must also possess at least one of the following characteristics: characteristic of relevance. To be useful, accounting must • Predictive Value. Before economic decision makers commit resources to one provide information to decision alternative instead of another, they must satisfy themselves that a reasonable makers that can be used to expectation of a return on investment and a return of investment exists. predict the future and timing Accounting information that helps reduce the uncertainty of that expectation of cash flows. has predictive value. or feedback value A primary characteristic of relevance. • Feedback Value. After making an investment decision, the decision maker To be useful, accounting must must have information to assess the progress of that investment. The decision provide decision makers with maker might want to reevaluate the decision if new information becomes information that allows them available and would centainly want to evaluate of the final outcome of the to assess the progress of an decision. If accounting information provides input for those evaluations, it investment. has feedback value. verifiability A primary characteristic of reliability. Information is considered Reliability verifiable if several individuals, working independently, would To be considered reliable, accounting information must possess four qualities: arrive at similar conclusions • Verifiability. We consider accounting information verifiable if several using the same data. qualified persons, working independently of one another, would arrive at representational faithfulness similar conclusions using the same data. For example, if we asked several A primary characteristic of people to determine the amount of Michael Simpson’s wages this year, they reliability. To be useful, should all come to the same conclusion: A simple review of payroll records accounting information must should provide verifiable information for the amount. reasonably report what actually • Representational Faithfulness. There must be agreement between what the happened. accounting information says and what really happened. If a company’s accounting information reports sales revenue of 1,000 and the company really 40 Chapter 2 Economic Decision Makinghad sales revenue of 1,000, the accounting information is representationally faithful. However, if a company’s accounting information reports sales revenue of 1,000 and the company really had sales revenue of only 800, then the accounting information lacks representational faithfulness. neutrality A primary charac- • Neutrality. To be useful, accounting information must be free of bias, which teristic of reliability. To be means accountants should not omit details simply because the information is useful, accounting information unpleasant. We have stressed how difficult it is to make good decisions. The must be free of bias. problem becomes even worse when information is suppressed or slanted, either positively or negatively. The need to remain neutral is one of the most difficult challenges facing the accounting profession. conservatism A character- • Conservatism. There are times when the concept of neutrality needs to be istic of reliability. In times of altered. These times generally occur under conditions of uncertainty, when uncertainty, it is better to there can be no objective, verifiable method of determining the valuation of underestimate the wealth and assets or revenues. In this case it is better to understate their value rather than income of a business rather risk overstating it. This applies conversely with liabilities and expenses. When than overestimate it. in doubt, it is better to overstate the liability or expense. This does not mean you deliberately misrepresent the value of these items; rather, it is better to understate the wealth and net income of a business than overstate it. Comparability and Consistency Two secondary qualities of useful accounting information are comparability and consistency. Economic decision makers evaluate alternatives. Accounting infor- mation for one alternative must therefore be comparable to accounting informa- tion for the others. For example, assume you intend to make an investment in one of two companies. If each company uses different accounting methods, you would find it very difficult to make a useful comparison. Now consider the concept of consistency. Imagine how difficult it would be to assess the progress of an investment if, through the years, different accounting treatments were applied to similar events. Consistency in the application of mea- surement methods over periods of time increases the usefulness of the accounting information provided about a company or an investment alternative. Comparability is a quality of information from different entities or alterna- tives. Consistency describes information from the same source over time. Comparability and consistency often have similar effects on the decision-making process. Their presence increases the decision maker’s confidence in his or her decision. The absence of these qualities decreases the decision maker’s confidence or confounds the decision maker’s ability to make a decision. REALITY VERSUS THE MEASUREMENT OF REALITY A firm performs the following four functions: 1. it operates to produce revenues, 2. it invests resources to enable it to operate, 3. it finances its operations and investments from internal and external sources, and 4. it makes decisions. These activities constitute the reality of conducting business. Reality happens every moment of the business day. To keep records of business transactions, the firm’s officers must measure the reality of each event. But remember this: No mat- ter how accurately the measurement of reality reflects that reality, it is not the reality. Chapter 2 Economic Decision Making 41To illustrate this concept, think of a person giving testimony in court. A court reporter records the exact words uttered by the witness and the transcript accu- rately measures the reality of the words spoken. If Rob reads the trial transcript and Keri hears the testimony in court, could Rob and Keri draw different conclusions about the substance of the testimony? Discussion Questions 2–11. What is the difference between the transcript testimony and the actual testimony? 2–12. Is there any other measurement of the testimony that might better reflect the reality of the testimony? Errors in measurement create more distortion between reality and the mea- surement of reality. Assume Laura’s Business purchased some office supplies and wrote a cheque for 480. In recording the cheque in the cheque register, the accoun- tant read the amount of the cheque incorrectly and entered 48. After the 48 was deducted, the cheque register indicated a balance of 1,127. However, the fact that the accountant entered the wrong amount for the cheque in no way changes the reality of how much money was spent and how much actually remains in the com- pany’s chequing account. Discussion Questions 2–13. Assuming the accountant made no other errors in the check register, what is the actual cash balance in Laura’s Business’s chequing account? 2–14. In what ways could this incorrect measurement of reality have an effect on reality? Explain. We can easily grasp the concept that errors may cause differences between real- ity and the measurement of reality. Many people, however, find it difficult to understand that sometimes perfectly legitimate differences exist between reality and its measure. This discrepancy can best be demonstrated in the measurement of the revenues and expenses to be reported in the income statement of a company for a particular time period. The Problems of Periodic Measurement periodicity The assumption Most discrepancies between reality and its measurement occur when earnings that the economic activities of activities are measured for a specific period of time (Exhibit 2–5). An accounting an entity can be traced to assumption of the conceptual framework, called periodicity, states that the eco- some specific time period and nomic activities of an entity can be traced to some specific time period and the results of those activities can results of those activities can be reported for any arbitrary time period. The be reported for any arbitrary assumption is often easier to understand than the practice of determining which time period chosen. 42 Chapter 2 Economic Decision Makingrevenues and which expenses should be included in the earnings (net income) of a particular period (month, quarter, or year). In fact, the only final measure of net income for a company is a comparison between revenues and expenses over the entire life of that company. Exhibit 2–5 2003 2004 2005 2006 Periodic Measurement 1 Year 1st quarter 2nd quarter 3rd quarter 4th quarter In some ways, determining net income in the fifteenth century was easier and more precise than it is today. In the era of Christopher Columbus, if an entrepre- neur planned to sail to the New World and bring back goods to sell, the net income for that particular venture could be measured. The entrepreneur began with a sum of money. With those funds, he bought a ship and supplies and hired men to help with the expedition. The group would set sail, gather treasures and commodities from the New World, return, and sell the goods. Then the entrepreneur paid the workers, sold the ship, and counted the money. If the ending money exceeded the beginning funds, the difference was a net income. If the beginning money exceeded the ending funds, the entrepreneur suffered a loss on the venture. In today’s world, it is unrealistic to expect a company to stop operations and sell off all its assets to determine its “true” net income. So although lifetime net income is the only precise measurement of an operation’s success or failure, users of accounting information demand current information every year, or quarter, or month. Only the need to artificially break the company’s operations into various time periods requires us to make decisions about when revenues and expenses recognition The process should be reported. of recording an event in the accounting records and reporting it on the financial Revenue and Expense Recognition statements. In accounting, the term recognition has a very specific meaning. It refers to the revenue An accounting process of (1) recording in the books and (2) reporting on the financial statements. element representing the The problem of when to recognize an item applies to all the accounting ele- inflows of assets as a result of ments that we will discuss. The greatest difficulties, however, occur in deciding an entity’s ongoing major or when to recognize revenues and expenses. central operations. This is the What exactly is revenue? Revenue is an accounting element representing the reward for doing business. inflows of assets as a result of an entity’s ongoing major or central operations. In expense An accounting other words, it is the reward for doing business. Revenue may simply be described element representing the as the increase in wealth from engaging in a particular business transaction. outflow of assets resulting Alternatively, expense is an accounting element representing the outflow of assets from an entity’s ongoing major resulting from an entity’s ongoing major or central operations (the sacrifice to gen- or central operations. This is erate revenue). Examples of expenses include salaries, rent, insurance, and adver- the sacrifice required to attain the rewards (revenues) of tising. An expense can therefore be thought of as a decrease in the wealth of a doing business. business. All businesses exist to generate revenues (and to avoid expenses). Chapter 2 Economic Decision Making 43 January February March April May June July August September October November DecemberThe net income (or loss) of a business is the difference between the revenues generated and expenses incurred over a particular period of time. All revenues and their related expense activities must be recorded in the same fiscal period by the business to arrive at a reliable net income figure. Chapter 5 will describe the process of calculating net income in greater detail. But for now, remember the fol- lowing equation: Revenue  Expenses  Net Income (or Net Loss) When should a revenue be recognized? When should an expense be recog- nized? These are two difficult questions, for which there are no perfect answers. The accounting establishment had to set criteria to determine when to recognize accounting elements, particularly revenues and expenses. Over time, the account- ing profession developed several different recognition systems, each attempting to find some rational basis for the measurement of revenue and expense in a particu- lar time period. Discussion Questions 2–15. Revenue is defined as the reward of doing business. At what point in the cycle of sales, from the customer’s order point to the seller’s delivery to the customer, do you think a sale should be recognized as revenue? Explain. 2–16. If an expense is defined as the sacrifice necessary to obtain a revenue, at what point in the sales cycle do you think an expense incurred to make a sale should be recognized? Explain. Bases of Economic Measurement There are two basic approaches to recording economic activity. Each presents a dif- ferent measurement of reality. Each depicts a different, but important, version of the measurement of accounting elements, especially revenues and expenses. We will use a single set of data to illustrate the two bases of measurement. Consider the following information concerning McCumber Enterprises (a propri- etorship) for January 2004: 1. Gertie McCumber started the company on January 2 by investing 200,000. 2. McCumber Enterprises borrowed 100,000 from the Friendly Bank on January 2 by signing a one-year note payable (ignore the interest for now). 3. The company purchased a vehicle on January 2 for 14,000 cash. Gertie estimates that the vehicle will fill the company’s needs for four years, after which she estimates she can sell it for 2,000. 4. The company paid cash for 75,000 of merchandise inventory on January 8. 5. On January 15, the company sold merchandise that cost 42,000 for a total selling price of 78,000 and collected the cash the same day. 6. On January 22, the company sold merchandise that cost 15,000 for a total selling price of 32,000 on account (a credit sale). The terms of the sale were 30 days, meaning McCumber Enterprises can expect to receive payment by February 21. 7. Cash payments for operating expenses in January totalled 22,500. 44 Chapter 2 Economic Decision Making8. Besides the bank loan, the only amounts owed by the company at the end of the month were: a. 2,000 to company employees for work performed in January. They will be paid on February 3. b. A 700 utility bill that was received on January 26 and will be paid on February 15. This information is the reality of what happened in McCumber Enterprises during January 2004. The measurement of that reality will be different, depending on the basis of accounting used to recognize the transactions. Remember, both treatments we will show are based on exactly the same reality—they are simply different methods of measuring that reality. CASH BASIS OF ECONOMIC MEASUREMENT cash basis accounting The first approach to measuring economic activity is cash basis accounting—the A basis of accounting in which simpler of the two bases. Everyone understands what cash is and can readily grasp cash is the major criterion used the measurement criterion of this method. Its greatest strength, however, lies in the in measuring revenue and fact that it keeps the user’s eye on the ball. As its name implies, the cash basis has expense for a given income only one measurement criterion: CASH statement period. Revenue is Under cash basis accounting, we recognize economic activity only when the recognized when the associ- associated cash is received or paid. Consequently, we recognize a revenue only ated cash is received, and when the company receives the associated cash as a result of the earnings process. expense is recognized when But not all cash received by a firm is revenue. When cash is received from company the associated cash is paid. owners, the inflow of assets is not due to ongoing operations but due to an owner’s investment. When cash is received from lenders, the amount owed to an outside party increases. Again, the inflow of assets is not due to ongoing operations. Similarly, we do not recognize all cash paid out as an expense in cash basis accounting. When a company pays a dividend to its owners, we recognize the expenditure not as a company expense, but as a distribution of profits or a return on the owners’ original investment. Cash Basis Revenue Recognition The cash basis has two criteria for revenue recognition: 1. Cash must be received, or realized, in the transaction. In accounting realization Actual receipt of terminology, realization occurs. cash or payment of cash. Once 2. The receipt of cash must relate to delivering or producing goods, rendering cash has been collected or a services, or other business activities. transaction is complete, it is If a transaction meets both these requirements, we recognize it as a revenue for considered to be realized. cash basis accounting and report it on the income statement. Cash Basis Expense Recognition The cash basis has two criteria for expense recognition: 1. Cash must be paid in the transaction. 2. The disbursement, or payment, must relate to delivering or producing goods, rendering services, or conducting other business activities. Chapter 2 Economic Decision Making 45If a transaction meets both these requirements, we recognize it as an expense for cash basis accounting and report it on the income statement. Cash Basis Accounting As the previous two sections have illustrated, in order to complete the equation Revenue  Expenses  Net Income, we need to determine which of the cash receipts are revenues and which are additions to capital, and which are increases in the amounts owed to outside parties. Alternatively, not all cash outflows are expenses. Some may be reductions in the amounts owed to outside parties (paying off a debt), while others may be a distribution of the wealth of the business to the owners (dividends). Therefore in order to calculate the net income of McCumber Enterprises, we need to determine (recognize) which of the cash items are revenues and which are expenses. From our example of McCumber Enterprises, only the fol- lowing activities meet the recognition criteria: 1. The company purchased a vehicle on January 2 for 14,000 cash. Gertie estimates that the vehicle will fill the company’s needs for four years, after which she estimates she can sell it for 2,000. Under cash basis accounting, the 14,000 purchase is considered an expense in January. 2. The company paid cash for 75,000 of merchandise inventory on January 8. This is considered an expense in January. 3. On January 15, the company sold merchandise that cost 42,000 for a total selling price of 78,000 and collected cash the same day. The sale of 78,000 is considered revenue because the company received the cash. The cost of the merchandise is not an expense at this point, because it was already recorded as an expense when it was purchased on January 8 (item 2). 4. Cash payments for operating expenses in January totaled 22,500. All the other activities that occurred during January were either contributions by the owner (200,000), amounts owed to outside parties (borrowing 100,000 from the bank), or did not involve cash (the sale on account for 32,000). The money owed to employees and the utility bill will only become expenses when they are paid (as stated, in February). We can record these activities according to whether they are revenues or expenses (see Exhibit 2-6). Exhibit 2–6 Results of Cash Basis Date Revenue () Expenses () Net Income Loss Accounting Jan. 2 14,000 (14,000) Jan. 8 75,000 (89,000) Jan. 15 78,000 (11,000) January 22,500 (33,500) Totals 78,000 111,500 (33,500) Consider the following items from Exhibit 2–6: • Revenue. Because McCumber Enterprises received only 78,000 in cash from sales in the month of January, only that amount meets both cash basis revenue recognition criteria (cash received, and cash related to delivering goods or services). 46 Chapter 2 Economic Decision Making• Expenses. The 111,500 is the total of the expenses for the month of January because it meets both of the expense recognition criteria (cash was paid, and cash related to delivering goods or service). Therefore, when we calculate McCumber Enterprises’ net income for the month of January, we find that the company experienced a loss of 33,500. But let’s not forget about the other two cash transactions. Gertie originally con- tributed 200,000 to the business, and the company borrowed an additional 100,000 from the bank. So the company started out with 300,000 cash in its bank account, and under the cash basis of accounting it lost 33,500, so the company’s net cash wealth is 266,500 (300,000  33,500). This would correspond to the cash balance in the company’s bank account at the end of January. All the other events did not include a cash component, so therefore they have no effect on the com- pany’s net cash wealth. As we will see in Chapters 3 and 4, the net wealth (called owners’ equity) of a business is reported on the balance sheet of the business. The balance sheet displays the total of everything a business owns (assets), minus what it owes (liabilities). In Chapter 5, we will cover the income statement, which is where the revenues and expenses of a business are recorded. Discussion Questions 2–17. Assume for a moment that you are McCumber Enterprises’ loan officer at the bank. How would you evaluate the revenue and expense presented in Exhibit 2–6 in terms of the primary qualitative characteristic of relevance, including predictive value and feedback value? 2–18. If your response to Discussion Question 2–17 led you to the conclusion that there is a problem in terms of predictive value and feedback value, what item or items do you believe caused the problem? How do you think the company could account for the item or items to better relate costs to the revenues they generate? Strengths and Weaknesses of Cash Basis Accounting Besides its relative simplicity, the greatest strength of the cash basis of accounting is its objectivity. Cash basis accounting presents the reality of cash, an important reality in conducting a business. Cash basis accounting requires less subjective judgment than the other measurement basis. The cash basis has a weakness that prevents it from being the perfect measurement basis, however. Management can easily manipulate revenues and expenses reported in a particular income state- ment period simply by speeding up or delaying the receipt of revenues or the pay- ment of amounts owed on expenses. The greatest weakness of the cash basis is that it makes no attempt to recognize expenses in the same period as the revenues they helped generate, offering a poor measurement of the reality of performance. This problem makes the cash basis income statement difficult to use either for predict- ing future profitability or for assessing past performance in cases where the com- pany does not always receive cash at the point of sale or pay for expenses when it receives the goods and services. Chapter 2 Economic Decision Making 47Discussion Question 2–19. Provide two examples of situations in which your chequebook balance did not provide relevant information. ACCRUAL BASIS OF ECONOMIC MEASUREMENT accrual basis accounting The second basis of economic measurement is accrual basis accounting. The A method of accounting in accrual basis does not rely on the receipt or payment of cash to determine when which revenues are recognized revenues and expenses should be recognized. The key to understanding accrual when they are earned, regard- basis accounting is to understand the word accrue. To accrue means less of when the associated cash is collected. The To come into being as a legally enforceable claim. expenses incurred in gener- ating the revenue are recog- Essentially, in accrual basis accounting, sales, purchases, and all other business nized when the benefit is transactions are recognized whenever a legally enforceable claim to the associated derived rather than when the cash is established. The main focus of accrual accounting is determining when a associated cash is paid. legally enforceable claim to cash has been established between the parties involved accrue As used in in the transaction. accounting, to come into being as a legally enforceable claim. Accrual Basis Revenue Recognition Accrual accounting has two criteria for revenue recognition: 1. Revenue must be earned; that is, the earning process must be substantially complete. 2. There must be a legally enforceable claim to receive the asset traded for the revenue. When a legally enforceable claim exists, the cash or other asset receivable Money due to becomes a realizable asset such as an account receivable. In the cash basis, the an entity from an enforceable cash receipt had to be realized. In the accrual basis, it must only be realizable. claim. Both criteria must be met to recognize revenue. Three possible relationships can exist between the timing of the cash move- ment and the recognition of the revenue. 1. Cash is received at the time the revenue is earned. When you pay cash for a pair of Gap jeans, the Gap recognizes revenue at the point of sale. Delivery of the jeans constitutes completion of the earning process and your payment of cash realizes receipt of cash. Both criteria are met because the revenue is earned and realized. 2. Cash is received after the revenue has been earned. When you go to Office Depot to buy supplies for your office and Office Depot allows you to pay next month on a 30-day charge, Office Depot will receive your cash after the revenue has been earned. Delivery of the supplies completes the earning process and your signing of the invoice gives the store an enforceable claim to your cash. 3. Cash is received before the revenue has been earned. If you subscribe to Maclean’s magazine for one year, you pay the subscription at the beginning of the year. Maclean’s realizes your cash but has not yet earned it. The earning process will not be complete until Maclean’s delivers a whole year’s worth of weekly issues to you. 48 Chapter 2 Economic Decision MakingBecause revenue must be earned before it can be recognized, the timing of the cash receipt is irrelevant. When the earning process is substantially complete and an enforceable claim exists to receive the cash, then the revenue is recognized. In Examples 1 and 2, the revenue is recorded in the books and shown on the financial statements at the time the sale is made. The fact that in Example 2 the company did not receive cash at that time does not affect recognition of the revenue. In Example 3, the receipt of cash does not cause revenue to be recognized because, under accrual accounting, the revenue is not recognized until it is earned (when the pub- lisher sends the magazines to the customer). Identifying the point in time when a revenue is earned is not always a sim- ple matter. Accountants try to answer three questions in determining when rev- enue has been earned and therefore should be recognized. To emphasize that these questions are in no way related to the three examples, we are using letters to list them. a. Has title (legal ownership) to whatever was sold been transferred to the customer? If the answer to this question is yes, revenue should be recognized. This question can be applied more easily to the sale of tangible products than to the sale of services. Services must be substantially complete to recognize revenue. b. Has an exchange taken place? Each party to the exchange gives the other party something of value—goods and services in exchange for cash or receivables. In other words, has the customer taken receipt of whatever he or she purchased? If the answer to this question is yes, the revenue will likely be recognized. c. Is the earnings process virtually complete? This is the toughest of the three questions to answer and applies better to the sale of services than it does to the sale of tangible products. Suppose you have contracted with Bill Austin to remodel your kitchen. It is a two-week job, and at the end of the second week, Bill has completed everything but changing the lamp over the dinette area. He ordered the lamp two months ago, but the supplier back-ordered it. It should arrive within another week. Has Bill substantially completed the work? Probably yes. He can recognize the revenue because the job is “virtually” complete. It is not necessary for all three questions to be answered “yes” for revenue to be rec- ognized. In most cases, a positive answer to any one of them is persuasive evidence that revenue has been earned and should be recognized. Discussion Questions 2–20. On Saturday morning, you finally decide which model of computer to buy. The salesperson has agreed to have all the software you need installed and have the machine delivered to you by Tuesday afternoon. Because you purchased your last computer at Image Technologies, the store has agreed to extend credit to you as an established customer. You have 30 days to pay for your new computer. As of Monday, a. has title passed? b. has an exchange taken place? c. is the earnings process complete? 2–21. When should Image Technologies recognize revenue a. under the cash basis? b. under the accrual basis? Chapter 2 Economic Decision Making 49Accrual Basis Expense Recognition Under accrual accounting, there is only one criterion for expense recognition: A firm recognizes an expense when it receives the benefit from the expense. Like rev- enue recognition, expense recognition under accrual accounting is unrelated to the movement of cash. Again, there are three possible relationships between the timing of the cash movement and the recognition of an expense. 1. Cash is paid at the time the expense is incurred. If a company holds a Christmas party and pays for the food when the caterer delivers it, the company receives the benefit of the expense at the same time it transfers the cash to the vendor. 2. Cash is paid after the expense has been incurred. A public utility cannot immediately exchange electricity for cash and must bill its customers on a monthly basis. When a firm receives and pays an electric bill, it expends the cash after the receipt of the electric service. 3. Cash is paid before the expense has been incurred. All insurance contracts require cash in advance to issue the policy and keep it in force. The policy expires or the expense occurs for each day as time passes during the policy’s time span. Discussion Question 2–22. Why would insurance companies require policies to be paid in advance? If the one criterion for expense recognition is receiving the benefit from the expense, how do we know when the expense benefits the firm? For the most part, the key to expense recognition under accrual accounting is revenue recognition. Remember that to be useful for predicting future profitability and cash flow, an income statement should measure revenues for a specific period of time and the expenses required to obtain those revenues. Thus, accrual accounting attempts to capture the relationship between revenues and expenses. This relationship is referred to as matching. If we re-examine the McCumber Enterprises transactions for January under the accrual basis of accounting (recognizing revenues and expenses), we will find that the company’s net income is different than the 33,500 loss that was recorded the using the cash basis of accounting. First, it is largely irrelevant whether or not cash was actually received or paid out. As with cash basis accounting, the 200,000 that Gertie started the company with on January 2 is not a revenue because it does not meet the criteria of being a revenue. The company is neither richer nor poorer (no change in its net wealth) as a result of this transaction. This is the same for the 100,000 borrowed from the bank on January 2 (still ignoring interest). The company may have 100,000 more in its bank account, but it now owes the bank 100,000; therefore there is no change in net wealth. The first difference between cash and accrual accounting is the vehi- cle purchased on January 2 for 14,000—it is not an expense under accrual account- ing. The vehicle is only recognized as an expense when it is actually used to generate revenue. At this point, all the company has done is exchange one asset (cash) for another asset (the vehicle). There has been no change in net wealth. What the vehicle might be worth at the end of four years (2,000) is irrelevant. 50 Chapter 2 Economic Decision MakingThe merchandise purchased on January 8 for 75,000 is not an expense under accrual accounting. Just as with the vehicle, all the company has done is exchange one asset for another. When the company actually sells the merchandise, then it will record the cost of the merchandise sold as an expense. This occurs on January 15, when the company sold merchandise that cost 42,000 for 78,000 cash. The 42,000 is considered an expense of the business (called Cost of Goods Sold). The 78,000 is revenue, and the 42,000 is an expense. On January 22 the company sold merchandise that cost 15,000 for 32,000 (credit sale). It did not receive cash for this sale, but did receive something else of value. That thing of value is the cus- tomer’s promise to pay cash at some future date (called an account receivable). This is considered revenue just as if the company had received cash (and the 15,000 is an expense). The cash payments (22,000) for expenses incurred in January are expenses just like under cash basis accounting. The thing to remember is that those expenses must have been incurred in January for them to be considered an expense in January. It actually does not matter whether they were paid in January (but in this case they were). The 2,000 still owed to the company’s employees is an expense for the month of January (since that is when the employees did the work), and, likewise, the 700 utility bill is also an expense in January. The fact that these expenses will not be paid until February is irrelevant. Just as with cash basis accounting, we can record these activities according to whether they are revenues or expenses (see Exhibit 2.7). Exhibit 2–7 Results of Accrual Date Revenue () Expenses () Net Income Basis Accounting Jan. 15 78,000 42,000 36,000 Jan. 22 32,000 15,000 53,000 January 22,000 31,000 January 2,000 29,000 January 700 28,300 Totals 110,000 81,700 28,300 Under accrual basis accounting, we can see that in January, McCumber Enterprises experienced a profit of 28,300. Under cash basis accounting the com- pany recorded a loss of 33,500. Which is correct? Well, they both are correct because they are both recording the same events, but in different ways and at different times. We can see that ultimately there is a considerable difference between cash basis and accrual basis accounting when we look at McCumber Enterprise’s net wealth. Cash basis accounting never took into consideration the 100,000 the company owes the bank. Nor did it consider that the company owns a valuable asset (the vehicle worth 14,000). The company still has unsold merchandise that cost 18,000 and a customer that owes 32,000. Additionally, the company owes its employees 2,000, and has an unpaid utility bill for 700. Therefore, in order to calculate McCumber Enterprises’ net wealth, we need to take all these things into consideration. The company still has 266,500 in the bank (that doesn’t change). Subtract from that the 100,000 owing to the bank, add the value of the vehicle (14,000), add the remaining inventory (18,000), add the money owed by the customer (32,000), subtract the money owed to employees (2,000) and subtract the utility bill (700). This gives McCumber Enterprises a net wealth of 227,800. Chapter 2 Economic Decision Making 51

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