Financial Accounting For Dummies. Maire Loughran

understand who uses financial accounting information, I can discuss the substantive characteristics of that information. If financial accountants don’t assure that financial statement information has these characteristics, the statements aren’t worth the paper on which they’re printed.

      The information a company provides must be relevant, reliable, comparable, and consistent. In this section, I define what each characteristic means.

      Relevance

      Relevance is a hallmark of good evidence; it means the information directly relates to the facts you’re trying to evaluate or understand. The inclusion or absence of relevant information has a definite effect on a user’s decision-making process.

      Relevant information has predictive value, which means it helps a user look into the future. By understanding and evaluating the information, the user can form an opinion as to how future company events may play out. For example, comparing financial results from prior years, which are gleaned from the financial statements, can give investors an idea as to the future value of a company’s stock. If assets and revenue are decreasing while liabilities are increasing, you have a pretty good indicator that investing in this company may not be such a hot idea.

      Relevant information also has feedback value, which means that new relevant information either confirms or rebuts the user’s prior expectations. For example, you review a company’s financial statements for 2021, and your analysis indicates that the company’s sales should increase two-fold in the subsequent year. When you later check out the 2022 income statement, the company’s gross receipts have, indeed, doubled. Woohoo! With the relevant information in hand, you see that your prediction came true.

      

Timeliness goes hand in hand with relevance. The best and most accurate information in the world is of no use if it’s no longer applicable because so such time has elapsed that facts and circumstances have changed. Look at it this way: If you were in the market to replace your flat-screen TV, and you found out about a killer sale at the local electronics store the day after the sale ended, this information is utterly useless to you. The same thing is true with financial information. That’s why the SEC requires publicly traded companies to issue certain reports as soon as 60 days after the end of the financial period. (See Chapter 16 for more about this reporting requirement.)

      Reliability

      Reliability means you can depend on the information to steer you in the right direction. For example, the information must be free from material misstatements (meaning it doesn’t contain any serious or substantial mistakes). It also has to be reasonably free from bias, which means the information is neutral and not slanted to produce a rosier picture of how well the company is doing.

      Here’s an example of how a company would create biased financial statements. Say that a company has a pending lawsuit that it knows will likely damage its reputation (and, therefore, its future performance). In the financial statements, the company does not include a note that mentions the lawsuit. The company is not being neutral in this situation; it is deliberately painting a rosier picture than actually exists. (See Chapter 15 for my explanation of the purpose of financial statement notes.)

      Reliable information must be verifiable and have representational faithfulness. Here’s what I mean:

        A hallmark of verifiability is that an independent evaluation of the same information leads to the same conclusion as presented by the company. An accounting application of this concept could be an independent third party, such as an auditor, checking that the dollar amount shown on the balance sheet as accounts receivable (money owed to the company by customers) is indeed correct.

       Representational faithfulness means that if the company says it has gross receipts of $200,000 in the first quarter of 2021, it actually has receipts of $200,000 — not any other amount.

      Comparability

      Comparability means the quality of the information is such that users can identify differences and similarities among companies they are evaluating — or among different financial periods for the same company. For example, users need to know what particular GAAP the different companies they are examining are using to depreciate their assets. Without this knowledge, the users cannot accurately evaluate the relative worth of one company over the other.

      INDEPENDENT VERIFICATION OF ACCOUNTS RECEIVABLE

      Many companies sell goods or services to customers on account, which means the customer promises to pay in the future. When this happens, the amount of unpaid customer invoices goes into an account called accounts receivable. (See Chapters 7 and 10 for detailed info about accounts receivable.) For a business carrying a sizable amount of accounts receivable, an error in this account can have a material effect on the reliability of the income statement and balance sheet.

      Independent confirmation of the accounts receivable balance is done by sending requests for confirmation. Confirmations are form letters sent to customers listed in the accounts receivable subsidiary ledger (a listing showing all customers with a balance owed). The letters seek to verify the facts and figures contained in the company’s books. The confirmation form letter is usually brief, listing the total amount the company shows the customer owes at a certain date.

      Some confirmation letters ask for a response; others ask the customer to respond only if the information on the confirmation form is incorrect. An independent party, such as the company’s external certified public accountant (CPA), tallies the results of the confirmations and either verifies or refutes the amount the company asserts that its customers owe.

Consider a personal example: Think about the last time you purchased a laptop. To the novice computer buyer, the shiny black cases and colored displays all look pretty much the same. But the price of each model varies — sometimes substantially. Therefore, you have to ferret out the facts about each model to be able to compare models and decide on the best one for your needs. What do you do? You check out the manufacturer’s specs for each laptop in your price range, comparing such important facts as the size of the hard drive, processing speed, and (if you want to be truly mobile) the laptop’s size and weight. By doing so, you are able to look beyond outward appearance and make a purchasing decision based on comparative worth among your options.

      

Though the United States is developing a global marketplace, as of this writing, U.S. GAAP may differ significantly from accounting principles used by businesses in other countries. Therefore, comparing financial statements of a foreign-based company and a U.S.-based company is difficult.

      Consistency

Consistency means the company uses the same accounting treatment for the same type of accounting transactions — both within a certain financial period and among various financial periods. Doing so allows the user to know that the financial accountant is not doing the accounting equivalent of comparing a dog to a cat. Both are animals, both are furry, but as any pet owner knows, you have a basic lack of consistency between the two.

      

Keep in mind that a company is allowed to switch accounting methods if it has a valid business purpose for the switch; the company isn’t stuck using only one method throughout its existence. An example of a good reason for a switch in methods is if using a different accounting method presents a