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What's it all about?

What's It All About?

A financial statement may seem to be no more than a quantitative set of numbers which shows profit or loss for a given period of time and indicate a company's current financial position. But in order to prepare the statement many choices are made. Should an item be capitalized or expensed? When should revenue be recognized? Should a particular liability be included on the balance sheet or only footnoted? These decisions will be made based on an underlying conceptual framework of accounting and on certain qualitative criteria. These accounting concepts are outlined in six FASB Statements of Financial Concepts. The purpose of this month's column is to list some of those criteria, define them and offer a few examples.

Relevance - Does the information "make a difference?" Will it be useful to the decision maker? Relevance allows the user to confirm prior expectations or to estimate future requirements. The balance of cash in the bank will verify the hoped-for success of sales or indicate the need for future borrowing.

Timeliness - Information needs to be available to a user in time to allow for a valid decision. Information cannot be relevant if it is furnished after a decision has been made. The relevance of the amount of inventory on hand would be diminished if the information was not furnished on a timely basis before issuing a purchase order for more times.

Reliability - In order to be reliable, information must be reasonably free from error and bias. Data must be dependable. Reliability depends on validity, on verifiability and on neutrality. Valid amounts show the economic substance of a transaction. They are verifiable and measurable. Any information presented must not present a particular viewpoint or attempt to influence a decision. The contract price of an asset or the amount of cash in the bank are examples of reliable numbers.

Comparability - Information is much more useful when it can be compared with similar information about other businesses. Financial reports should provide information that can be related to the results of other similar companies or to more than one time period for the same company. When analyzing a financial statement, it is helpful to calculate the current ratio, but much more meaningful to compare that ratio to one from a similar company or to a prior year.

Consistency - The same accounting concepts and methods are applied over a series of reporting periods. Conclusions based on the comparison of results of operations from one period to another could be materially incorrect if different accounting methods were applied to each period. If FIFO inventory and straight line depreciation were used in one year and LIFO inventory and accelerated depreciation were used in the subsequent year, the financial statements would not be comparable unless the changes were properly disclosed.

Materiality - An item is material if the judgment of a reasonable person would have been changed by its omission or misstatement. Materiality decisions are applied to each situation separately. Materiality can relate to the manner in which an item is reported. The cost of a waste paper basket would be expensed and not carried as a depreciable asset because the amount was not material. Or an amount that may be material in one situation could be immaterial in another. A $10,000 loss may not be material to a major manufacturing firm, but could be very material to a small business.

Conservatism - When dealing with uncertainties or alternatives, conservatism means choosing the alternative with the least favorable outcome. This is not a deliberate understatement of assets, but an attempt to be prudent when making decisions that will affect the user of the financial statement. Reporting marketable securities at the lower of cost or market is an example of conservatism.

Realization - Revenue is realized when the earnings process is substantially complete and when there is a receipt of cash or of a collectible asset. The sale of goods for cash is an obvious example of realization.

Recognition - The process of formally recording an item in the accounts and reporting it in the financial statements. Realization and recognition are not synonymous. A sale of goods for cash is usually recognized at the time of completion, i.e. when the sale is realized. In some cases, gain or loss may be realized and not recognized or just the reverse, recognized, but not realized. A change in the value of securities may be recognized even though the securities are not sold and the change has not actually been realized. Under historical cost accounting, an obvious loss in the value of an asset due to technology changes may be realized, but not recognized.

Matching - The process of relating revenue and expenses to a particular period. If revenue is recognized in that period, then the expenses incurred in earning that revenue are also recognized during the same period. This is the basis of the accrual method of accounting. Some expenses are recognized on a direct basis and some on a time basis. Sales and delivery cost are examples of direct expenses, while insurance and depreciation expense are expenses which are expanded during the period of time revenue is earned.
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Title Annotation:Accounting Scene; financial statements
Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Article Type:Column
Date:Oct 1, 1991
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