Description
Accounting Measurement
To make an accounting measurement, the accountant must answer four basic questions:
■ What is measured?
■ When should the measurement be made?
■ What value should be placed on what is measured?
■ How should what is measured be classified?
Accountants debate the answers to these questions constantly, and the answers change as new knowledge and practice require. But the basis of today’s accounting practice rests on a number of widely accepted concepts and conventions. We begin by focusing on the first question: What is measured? We discuss the other three questions in the next chapter.
Business Transactions Business transactions are economic events that affect a business’s financial position. Businesses can have hundreds or even thousands of transactions every day. These transactions are the raw material of accounting reports.
A transaction can be an exchange of value (a purchase, sale, payment, collection, or loan) between two or more parties. A transaction also can be an economic event that does not involve an exchange. Some examples of nonexchange transactions are losses from fire, flood, explosion, and theft; physical wear and tear on machinery and equipment; and the day-by-day accumulation of interest.
To be recorded, a transaction must relate directly to a business entity. Suppose a customer buys toothpaste from CVS but buys shampoo from a competing store because CVS is out of shampoo. The transaction in which the toothpaste was sold is entered in CVS’s records. However, the purchase of the shampoo is not entered in CVS’s records because, even though it indirectly affects CVS economically (by losing a sale), it does not involve a direct exchange of value between CVS and the customer.
Money Measure All business transactions are recorded in terms of money. This concept is called money measure. Of course, nonfinancial information may also be recorded, but a business’s transactions and activities are measured through the record-ing of monetary amounts. Money is the only factor common to all business transactions, and thus it is the only unit of measure capable of producing financial data that can be compared. The monetary unit a business uses depends on the country in which the busi-ness resides. For example, in the United States, the basic unit of money is the dollar.
In China, it is the yuan; in Japan, the yen; in the European Union (EU), the euro; and in the United Kingdom, the pound. In international transactions, exchange rates must be used to translate from one currency to another. An exchange rate is the value of one currency in terms of another. For example, a British person purchasing goods from a U.S. company like CVS and paying in U.S. dollars must exchange British pounds for U.S. dollars before making payment. In effect, currencies are goods that can be bought and sold.
Exhibit 2 illustrates the exchange rates for several currencies in dollars. It shows the exchange rate for British pounds as $1.59 per pound on a particular date. Like the prices of many goods, currency prices change daily according to supply and demand. For example, a year and a half earlier, the exchange rate for British pounds was $1.63.
Separate Entity For accounting purposes, a business organization is a separate entity, distinct not only from its creditors and customers but also from its owners. It should have its own set of financial records, and its records and reports should refer only to its own affairs.
For example, Just Because Flowers Company should have a bank account separate from the account of Molly Dar, the owner. Molly Dar may own a home, a car, and other property, and she may have personal debts; but these are not the resources or debts of Just Because Flowers. Molly Dar may own another business, say a stationery shop. If she does, she should have a completely separate set of records for each business.
Forms of Business Organization
The three basic forms of business organization recognized as separate entities are the sole proprietorship, the partnership, and the corporation.
Sole Proprietorship A sole proprietorship is a business owned by one person. The owner takes all the profits or losses of the business and is liable for all its obligations. As Exhibit 3 shows, sole proprietorships represent the largest number of businesses in the United States, but typically they are the smallest in size.
Partnership A partnership is like a sole proprietorship in most ways, but it has two or more owners. The partners share the profits and losses of the business according to a prearranged formula. Generally, any partner can obligate the business to another party, and the personal resources of each partner can be called on to pay the obligations. A partnership must be dissolved if the ownership changes, as when a partner leaves or dies. If the business is to continue as a partnership after this occurs, a new partnership must be formed.
Corporation Both the sole proprietorship and the partnership are convenient ways of separating the owners’ commercial activities from their personal activities. Legally, however, there is no economic separation between the owners and the businesses. A corporation, on the other hand, is a business unit chartered by the state and legally separate from its owners (the stockholders). The stock-holders, whose ownership is represented by shares of stock, do not directly control the corporation’s operations. Instead, they elect a board of directors to run the corporation for their benefit. In exchange for their limited involvement in the corporation’s operations, stock-holders enjoy limited liability; that is, their risk of loss is limited to the amount they paid for their shares. Thus, stockholders are often willing to invest in risky, but potentially profitable, activities. Also, because stockholders can sell their shares without dissolving the corporation, the life of a corporation is unlimited and not subject to the whims or health of a proprietor or a partner.
The characteristics of corporations make them very efficient in amassing capital, which enables them to grow extremely large. As Exhibit 3 shows, even though corporations are fewer in number than sole proprietorships and partnerships, they contribute much more to the U.S. economy in monetary terms. For example, in 2011, ExxonMobil generated more revenues than all but 28 of the world’s countries.3