Bourgeois society is infected by monomania: the monomania of accounting. For it, the only thing that has value is what can be counted in francs and centimes. It never hesitates to sacrifice human life to figures which look well on paper, such as national budgets or industrial balance sheets.
Financial Reporting Theory (Part C)
by
Charles Lamson
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Recall from part 8 that Fundamental characteristics are those basic characteristics that distinguish useful financial information from information that is not useful. The FASB identifies the two fundamental characteristics as relevance and faithful representation. In part 8 we discussed relevance. This post focuses on faithful representation.
Faithful Representation. The second qualitative characteristic, faithful representation, indicates whether financial information depicts the substance of an economic event in a manner that is
The depiction of an economic event is considered complete if it includes all information---both descriptions and explanations---necessary for the financial statement user to understand the underlying economic event. For example, a company reports a balance of long-lived assets on its balance sheet. From this one amount, a financial statement user cannot fully understand the company's investment in its long-lived assets. A complete depiction of a company's long-lived assets includes a description of the nature of the assets, the balance by type, and a description of the depreciation method used for each type. For example, Johnson & Johnson reported $15,905 million of net property, plant, and equipment in its January 3, 2016, balance sheet representing about 12% of its total assets. It presents its property, plant, and equipment in more depth in its footnotes to the financial statements to provide a more complete depiction of the company's property, plant, and equipment. In the footnote, Johnson & Johnson includes the amount of each major class of property, plant, and equipment such as the $22,511 million of machinery and equipment. After the table, Johnson & Johnson includes other information in its property, plant, and equipment such as the amount of capitalized interest expense and depreciation expense. Exhibit 2.4 presents note 4 from Johnson & Johnson's 2015 annual report. %20(1)%20(1).jpg) In its financial statement notes, Johnson & Johnson also states that its property, plant, and equipment are reported at cost. The company indicates that it depreciates plant and equipment using the straight-line method [Straight line basis is a method of calculating depreciation and amortization, the process of expensing an asset over a longer period of time than when it was purchased. It is calculated by dividing the difference between an asset's cost and its expected salvage value by the number of years it is expected to be used (investopedia.com).]and provides estimated useful lives. Further, the company identifies and reports the historical cost of four different categories of property, plant, and equipment. Johnson & Johnson also reports the total accumulated depreciation on these assets.  Information is neutral if it is free from bias in both the selection and presentation of financial data. For example, assume that Haster Incorporated has three lawsuits pending at the end of the year. It discloses information only about the lawsuit that it expects to have a favorable outcome but not the two for which it expects unfavorable outcomes. This biased reporting does not faithfully represent the firm's financial position. Information is reported free from error when there are no mistakes or omissions in the description of an event or in the process used to produce the financial information. However, the information need not be accurate in all respects. Specifically, firms report a significant amount of financial information based on estimates. For example, companies estimate the amount of receivables that will ultimately become uncollectible. Because the amount of uncollectible receivables is an estimate, the actual amount could be different. Enhancing Characteristics Even if information is relevant and representationally faithful, it may not be the most useful data available for decision making. The FASB identifies the following four enhancing characteristics that help distinguish more useful information from less useful information:
Comparability. Investors and creditors must be able to compare entities in making capital allocation decisions. Comparability allows financial statements users to identify and understand similarities and differences among several entities. Accounting standards often allow alternative methods, such as straight line or accelerated depreciation, and require estimates, like the useful lives of long-lived assets. A company's financial information is useful if financial statement users can compare it with similar information from another company, companies in its industry, or to its prior year. For example, the requirement to disclose the useful lives of long-lived assets allows financial statement users to compare the aircraft fleets of American Airlines and Delta Airlines. American uses a 16- to 30-year useful life for its fleet whereas Delta uses a 20- to 32-year useful life. The differing useful lives imply that American has aircraft with a shorter useful life and probably has different types of planes in its fleet from Delta.  Verifiability. Verifiability means that a group of reasonably informed financial statement users are able to reach a consensus decision that reported information is a faithful representation of an underlying economic event. For example, two independent accountants would agree that a company owes $100,000 to a commercial bank by examining the loan agreement. Timeliness. Timely information is available to financial statement users early enough to make a difference in decision making. In the United States, public companies prepare financial statements every quarter and annually. Imagine trying to make an investment decision if financial statements were issued only every five years. You would possess outdated information irrelevant to decision making in the current period. Generally, older information is less useful than more recent information. Understandability. Information is understandable to reasonably informed financial statement users when financial statements classify, characterize, and clearly present all information. Because many companies are incredibly complex, it is very important to distill the vast amounts of financial data into a manageable report for users to read and understand. As an example of how financial statements are organized to aid understandability, companies separate current and non-current assets on their balance sheets. As a result, financial statement users can better understand a company's current and long-term resources. Cost Constraint Providing all relevant and representationally faithful information available is costly. As a result, the conceptual framework stipulates that standard-setters should compare the cost of requiring information to the benefits derived from presenting this information when developing accounting standards. Standard setters consider costs for both financial statement reporters and users.  A company consumes a significant amount of resources in collecting, processing, verifying, and communicating its financial results. New standards or significant revisions of existing standards require companies to increase training, update accounting systems, and renegotiate existing contracts based on updated accounting information. On the other hand, if the information required under a new standard is not provided to the users, they incur costs in obtaining or estimating that information on their own. To illustrate, assume that standard setters are considering requiring that retail stores report the sales and operating profit generated by each store by month. This information may be useful to investors and financial analysts. However, the cost of providing such detailed store by store information every month can be greater than its benefits. As a result, the information will not be required.  *GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., 28-31* end |
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