Chapter Two - Wiley

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8956d_ch02_056 7/21/03 12:36 PM Page 56 mac76 mac76:385_reb: 56 CHAPTER 2 A Further Look at Financial Statements Illustration 2-1 Characteristics of useful information A company can change to a new method of accounting if management can justify that the new method produces more useful financial information. In the year in which the change occurs, the change must be disclosed in the notes to the financial statements so that users of the statements are aware of the lack of consistency. The characteristics that make accounting information useful are summarized in Illustration 2-1. Tell me only what I need to know. I promise to tell the whole truth You could set your watch by this stagecoach. BIG SHOT Apples Oranges Which is better? Relevance 1. Provides a basis for forecasts 2. Confirms or corrects prior expectations 3. Is timely Reliability 1. Is verifiable 2. Is a faithful representation 3. Is neutral Comparability Different companies use similar accounting principles Consistency Company uses same accounting methods from year to year STUDY OBJECTIVE 3 Identify two constraints in accounting. Helpful Hint In late 1999, the SEC issued stricter rules on materiality because it felt that too often companies were using materiality as an excuse not to report certain losses. Constraints in Accounting The characteristics we have discussed are intended to provide users of financial statements with the most useful information. Taken to the extreme, however, efforts to provide useful financial information could be far too costly to the company. Therefore, constraints have been agreed upon to ensure that accounting rules are applied in a reasonable fashion, from the perspectives of both the company and the user. Constraints permit a company to apply generally accepted accounting principles without jeopardizing the usefulness of the reported information. The constraints are materiality and conservatism. MATERIALITY Materiality relates to a financial statement item’s impact on a company’s overall financial condition and operations. An item is material when its size makes it likely to influence the decision of an investor or creditor. It is immaterial if it is too small to impact a decision maker. In short, if the item does not make a difference, GAAP does not have to be followed. To determine the materiality of an amount—that is, to determine its financial significance—the item is compared with such items as total assets, sales revenue, and net income. To illustrate how the constraint of materiality is applied, assume that Best Buy made a $100 error in recording revenue. Best Buy’s total revenue is $10 billion; thus a $100 error is not material. CONSERVATISM Conservatism in accounting means that when preparing financial statements, a company should choose the accounting method that will be least likely to overstate assets and income. It does not mean, however, that one should intentionally understate assets or income.
8956d_ch02_057 10/14/03 11:06 AM Page 57 mac76 mac76:385_reb: A common application of the conservatism constraint is in valuing inventories. Inventories are normally recorded at their cost. Conservatism, however, requires that inventories are written down to market value if market value is below cost. Conservatism also requires that when the market value of inventory exceeds cost, the value of the inventory is not increased on the books, but instead remains at cost. This practice results in lower net income on the income statement and a lower amount reported for inventory on the balance sheet. The two constraints are graphically depicted in Illustration 2-2. The Classified Balance Sheet 57 Materiality Conservatism Illustration 2-2 Accounting constraints For small amounts, GAAP does not have to be followed. When in doubt, choose the solution that will be least likely to overstate assets and income. BEFORE YOU GO ON . . . Review It 1. What are generally accepted accounting principles? 2. What is the basic objective of financial information? 3. What qualitative characteristics make accounting information useful? 4. What are the materiality constraint and the conservatism constraint? ■✓ THE NAVIGATOR SECTION TWO THE FINANCIAL STATEMENTS REVISITED In <strong>Chapter</strong> 1 we introduced the four financial statements. In this section we review the financial statements and present tools that are useful for evaluating them. We begin by introducing the classified balance sheet. The Classified Balance Sheet The balance sheet presents a snapshot of a company’s financial position at a point in time. To improve users’ understanding of a company’s financial position, companies often group similar assets and similar liabilities together. This is useful because it tells you that items within a group have similar economic characteristics. A classified balance sheet generally contains the standard classifications listed in Illustration 2-3. STUDY OBJECTIVE 4 Identify the sections of a classified balance sheet.
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Chapter Two - Wiley

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