Understandability and Comparability
For a user to understand financial statements, GAAP accounting requires that companies produce financial statements that are comparable with the company’s past performance over time, as well as against other entities. Therefore, accounting practices should be consistent with past financial statements and those of other companies. Changes in accounting practices can be made for economic reasons, and must be disclosed fully on the financial statements to pass the comparability test under audit. Companies must also identify the financial reporting methods they have selected in the footnotes to the financial statements.
For example, a company may choose the FIFO or LIFO cost flow assumption when assigning costs to inventory, but must disclose which method they are using. Additionally, when a company changes from one method to another, it must have a rationale for the change, and must report the cumulative financial impact resulting from a change in accounting methods.
Materiality
Materiality means information included or excluded from the financial statements would likely have a significant effect on a user’s decision. Materiality is relative to the company’s overall size. GAAP accounting principles contain no specific rule for determining materiality, but a company must look at both the amount and the nature of a transaction.
A company earning several thousand dollars a year must correctly report an asset of $1000, whereas a company worth several million dollars that misclassified the asset as an expense could consider the transaction immaterial. Additionally, materiality refers to the nature of the transaction. Smaller transactions that reveal an important transaction are considered material. A lawsuit that resulted in small punitive damages, for example, should be disclosed by reason of its nature rather than its amount, as it is more likely to affect a user’s decision.
Costs vs. Benefits
A company includes accounting information in its financial statements if the benefit of reporting the information exceeds the costs of obtaining the information. Since accounting information must also be disclosed timely, overly complex and detailed information is not required since the costs exceed the benefits. For example, disclosing sales is considered useful accounting information where benefits exceed the costs, and can be issued quarterly, yearly, and even monthly. Disclosing detailed schedules of sales by product and region is not required because it is not cost-effective for financial reporting purposes nor easily obtainable.
Conservatism
Conservatism attempts to minimize the risk of overstating financial statements. When faced with two or more options, GAAP accounting requires that a company choose the option that has the least favorable impact on net income and the balance sheet. Conservatism does not attempt to deliberately understate earnings or assets, but rather attempts to manage uncertainty requiring judgment as conservatively as possible to prevent overstating a company’s earnings or financial position.
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