GAAP Accounting Qualities: Relevance and Reliability

The primary characteristics of useful accounting information are both relevance and reliability.

GAAP Accounting and Relevance

Relevance includes any information that helps the financial statement user determine the value and performance of the company. Reporting the number of workers in each department is irrelevant. Reporting the total salaries and wages of employees is relevant.

Similarly, reporting the type of vehicles the company owns is not relevant. Reporting the original cost of the vehicles is relevant.

GAAP Accounting and Reliability

GAAP accounting also centers on the reliability of the information reported. Companies report information that is not biased towards an objective, such as getting investors to invest in its stock, or creditors to lend the company money. Instead, financial reports are reliable when users can rely on the information to represent that which it is intended to represent.

Information that is reliable can be verified independently and repeatedly. Reliability is the main reason companies are audited. Auditing tests and verifies that the financial information reported is accurate, reliable, and represents what it claims to represent so that financial statement users can depend on it to make financial decisions.

Relevance and Reliability

Financial statements must have both relevance and reliability to be useful, but these qualities are often in conflict. These differences were brought even more to light in the midst of the international financial meltdown and the increased use of fair value accounting to value assets and liabilities on the balance sheet.

Often times something that is considered reliable, such as recording an asset at historical cost, is not considered relevant to the current fair value of the asset. However, recording an asset at fair value may not be a reliable indicator of the true value of an asset. The historical cost of an asset is highly reliable because it is based on a historical, documented transaction that is rarely subject to debate. Most if not all independent observers would come to a consensus of the original cost by confirming the facts as documented in the original purchase transaction.

Even though decision makes consider historical cost reliable, other financial statement users may question its relevance based on the current market value of the asset. For example, the price paid for land or other assets purchased many years or even decades ago may be highly reliable, but bear little resemblance to its current market value. Some critics of current accounting standards, particularly the International Accounting Standards Board (IASB) and increasingly, FASB and even the SEC, are questioning the relevance of historical accounting information, and prefer to base GAAP accounting information on fair market values.

Relevance vs. Reliability?

In the ongoing debate of relevance and reliability, the question “What good is reliable information if it is not relevant?” can just as easily be, “What good is relevant information if it is not reliable?”

For example, the fair value of an asset is primarily what the market will pay for it. But this raises a new question: If the asset is not actually sold, who determines the value of the asset? FASB requires that the value be based on what market participants would pay (SFAS 157). Short of an actual sale, the fair value is determined by an appraiser’s estimate of the market value of an asset. The estimate of the fair value becomes just that: an estimate that is subject to a range of values based on what appraisers determine the price to be based on professional judgment and expertise.

The appraisal process also involves the challenging task of determining who the buyers are, and for what purpose the asset will be used, each of which affects the value of the asset.

The bottom line is that the appraised value of an asset is subject to opinions and judgments which makes it much more subjective and less reliable than historical cost.

The main argument for historical cost is that the cost is reliable and rarely subjective, with less leeway and thus less opportunity for fraud. The main argument against historical cost is that it is no longer relevant to current market conditions.

On the other hand, the main argument for valuing assets and liabilities at fair value is that fair value provides the greatest value by providing the most current and relevant information to financial statement users. However, fair value accounting is subject to extensive judgment that is therefore not as reliable as the historical cost principle, and therefore more susceptible to fraud.

In fact, fair value accounting rules are highly complex, and therefore provides the additional risk of not only error in classifying assets and liabilities, but the added risk of management intentionally misclassifying assets and liabilities for the purpose of boosting profits and minimizing losses.