Accounting information should be readily understandable and decision usefulness ( the ability to be useful in decision making) to the intended users of the information.
Understandability means that users must understand the information within the context of the decision being made. This is a user-specific quality because users will differ in their ability to comprehend any set of information. To be useful, information must make a difference in decision process.
Primary Qualitative Characteristics
The primary decision-specific qualities that make accounting information useful are relevance and reliability. Both are critical. No matter how reliable, if information is not relevant to the decision at hand, it is useless. Conversely, relevant information is of little value if it cannot be relied on. So, to be useful for decision making, accounting information should be relevant and reliable.
Relevance
-To make a difference in the decision process, information must possess
- Predictive value
- Feedback value (Generally, useful information will possess both qualities. For example, if net income and its components confirm investor expectations about future cash-generating ability, then net income has feedback value for investors. This confirmation can also be useful in predicting future cash-generating ability as expectations are revised.)
- Timeliness also is an important component of relevance. Information is timely when it is available to users early enough to allow its use in the decision process. The need for timely information requires that companies provide information to external users on a periodic basis. Information is timely if it is available to users before a decision is made.
Reliability
- Verifiability implies a consensus among different measurers. For example, the historical cost of a piece of land to be reported in the balance sheet of a company is usually highly verifiable. The cost can be traced to an exchange transaction, the purchase of the land. However, the market value of that land is much more difficult to verify. Appraisers could differ in their assessment of market value. The term objectivity often is linked to verifiability. The historical cost of the land is objective but the land’s market value is subjective, influenced by the measurer’s past experience and prejudices. A measurement that is subjective is difficult to verify, which makes it more difficult for users to rely on.
- Representational faithfulness means when there is agreement between a measure or description and the real-world phenomenon that the measure is supposed to represent. For example, assume that the term inventory in a balance sheet of a retail company is understood by external users to represent items that are intended for sale in the ordinary course of business. If inventory includes, say, machines used to produce inventory, then it lacks representational faithfulness.
- Reliability assumes the information being relied on is neutral with respect to parties potentially affected. In that regard, neutrality is highly related to the establishment of accounting standards. Changes in accounting standards can lead to adverse economic consequences to certain companies, their investors and creditors, and other interest groups. Accounting standards should be established with overall societal goals and specific objectives in mind and should try not to favor particular groups or companies.
Secondary Qualitative Characteristics
- Comparability is the ability to help users see similarities and differences between events and conditions. It is important to the investors and creditors to compare information across companies to make their resource allocation decisions.
- Closely related to comparability is the notion that consistency of accounting practices over time permits valid comparisons between different periods. The predictive and feedback value of information is enhanced if users can compare the performance of a company over time.
Cost effectiveness constraint
- the cost of producing such information should be reasonable in relation to the expected benefit.
Materiality constraint
Materiality constraint
- may not have to be fully followed for immaterial items if full compliance would result in unwarranted higher costs.
GAAP
Generally Accepted Accounting Principles (GAAP) is the rules adopted by the accounting profession as guides for measuring and reporting the financial condition and activities of a business. To use and interpret financial statements effectively, we need to have a basic understanding of these principles. The primary purpose of GAAP is to make information in financial statements relevant, reliable and comparable.
To achieve basic objectives and implement fundamental qualities, GAAP has four basic assumptions, four basic principles, and four basic constraints.
Assumptions
Business Entity -assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses.
Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. This assumption is not applicable when the liquidation is certain.
Monetary Unit principle: assumes a stable currency is going to be the unit of record.
Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods.
Principles
Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
Matching principle - Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, may cost be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.
Disclosure principle - Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information
Constraints
Objectivity principle - the company financial statements provided by the accountants should be based on objective evidence.
Materiality principle - the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
Consistency principle- It means that the company uses the same accounting principles and methods from year to year.
Prudence principle - when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.
GAAP
Generally Accepted Accounting Principles (GAAP) is the rules adopted by the accounting profession as guides for measuring and reporting the financial condition and activities of a business. To use and interpret financial statements effectively, we need to have a basic understanding of these principles. The primary purpose of GAAP is to make information in financial statements relevant, reliable and comparable.
To achieve basic objectives and implement fundamental qualities, GAAP has four basic assumptions, four basic principles, and four basic constraints.
Assumptions
Business Entity -assumes that the business is separate from its owners or other businesses. Revenue and expense should be kept separate from personal expenses.
Going Concern: assumes that the business will be in operation indefinitely. This validates the methods of asset capitalization, depreciation, and amortization. This assumption is not applicable when the liquidation is certain.
Monetary Unit principle: assumes a stable currency is going to be the unit of record.
Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods.
Principles
Cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
Revenue principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
Matching principle - Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, may cost be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.
Disclosure principle - Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information
Constraints
Objectivity principle - the company financial statements provided by the accountants should be based on objective evidence.
Materiality principle - the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
Consistency principle- It means that the company uses the same accounting principles and methods from year to year.
Prudence principle - when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.
