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Practical Boundaries (Constraints) to Achieving Desired Qualitative Characteristics
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Most of us learn early in life that we can’t get everything we desire. The latest electronic gadget may have all the qualitative characteristics that current technology can provide, but limited resources may lead us to purchase a fully functional model with fewer bells and whistles. Cost effectivenessthe perceived benefit of increased decision usefulness exceeds the anticipated cost of providing that information. also constrains the accounting choices we make. Specifically, it’s important that the benefits of endowing accounting information with all the qualitative characteristics we’ve discussed exceed the costs of doing so.

A related constraint on the type of information we provide is the concept of materialityif a more costly way of providing information is not expected to have a material effect on decisions made by those using the information, the less costly method may be acceptable.. For an additional $20 you can add the latest enhancement to that electronic gadget you’re considering. However, despite the higher specs, if you feel it will provide no discernible improvement in the performance of the product as you will use it, why pay the extra $20? In an accounting context, if a more costly way of providing information is not expected to have a material effect on decisions made by those using the information, the less costly method may be acceptable.

Cost effectiveness and materiality impart practical constraints on each of the qualitative characteristics of accounting information. Both suggest that a certain accounting treatment might be different from that dictated solely by consideration of desired qualities of information.

COST EFFECTIVENESS

The costs of providing accounting information include those of gathering, processing, and disseminating information. There also are costs to users when interpreting information. In addition, costs include possible adverse economic consequences of implementing accounting standards. These costs in particular are difficult, if not impossible, to quantify.

The costs of providing accounting information include any possible adverse economic consequences of accounting standards.

An example of this is the standard that requires companies operating in more than one operating segment to disclose certain disaggregated financial information.30 In addition to information gathering, processing, and dissemination costs, many companies feel that this reporting requirement imposes what could be called competitive disadvantage costs. These companies do not want their competitors to have the disaggregated data.

The perceived benefit from this or any accounting standard is increased decision usefulness of the information provided, which, hopefully, improves the resource allocation process. It is inherently impossible to quantify this benefit. The elaborate information-gathering process undertaken by the FASB in setting accounting standards is an attempt to assess both costs and benefits of a proposed accounting standard, even if in a subjective, nonquantifiable manner. In the case of reporting disaggregated information, the FASB decided that the perceived benefits of disclosing this information exceeded the costs of providing it.

Information is cost effective only if the perceived benefit of increased decision usefulness exceeds the anticipated costs of providing that information.

MATERIALITY

Materiality is another pervasive constraint. Information is material if it can have an effect on a decision made by users. One consequence of considering materiality is that GAAP need not be followed if an item is immaterial. For example, GAAP requires that receivables be measured at their net realizable value. If bad debts are anticipated, they should be estimated and subtracted from the face amount of receivables for balance sheet measurement. This is called the allowance method of accounting for bad debts. However, if the amount of anticipated bad debts is not considered to be large enough to affect decisions made by users, the direct write-off method of accounting for bad debts can be used even though it is not a generally accepted technique. This method does not require estimation of bad debts for existing receivables.

Information is material if it has an effect on decisions.

The threshold for materiality will depend principally on the relative dollar amount of the transaction. For example, $10,000 in total anticipated bad debts for a multibillion dollar company like FedEx would not be considered material. The method used to account for these anticipated bad debts will not affect the decisions made by FedEx Corporation’s financial statement users. This same $10,000 amount, however, could easily be material for a neighborhood pizza parlor. The FASB has been reluctant to establish any quantitative materiality guidelines. The threshold for materiality has been left to the subjective judgment of the company preparing the financial statements and its auditors.

Materiality is concerned not only with the dollar amount of an item but with the nature of the item as well. In 1999, the SEC issued Staff Accounting Bulletin No. 99.31 The bulletin expresses the SEC’s view that exclusive reliance on quantitative benchmarks to assess materiality in preparing financial statements is inappropriate. A number of other factors, including whether the item in question involves an unlawful transaction, should also be considered when determining materiality. For example, an activity such as the illegal payment of $10,000 to an official of a foreign government to secure a valuable contract would probably be considered material even if the amount is small relative to the size of the company.

Professional judgment determines what amount is material in each situation.

CONSERVATISM

Conservatismpractice followed in an attempt to ensure that uncertainties and risks inherent in business situations are adequately considered. is a practice followed in an attempt to ensure that uncertainties and risks inherent in business situations are adequately considered. It is a frequently cited characteristic of accounting information. Conservatism is not, however, a desired qualitative characteristic but a practical justification for some accounting choices. In that sense, conservatism serves as a third constraint on the achievement of various qualitative characteristics.32

Conservatism is a justification for some accounting practices, not a desired qualitative characteristic of accounting information.

The need for conservatism often is discussed in conjunction with the estimates required to comply with GAAP. For example, assume that a company estimated that its anticipated bad debts on existing receivables could be any number between $20,000 and $30,000, with the most likely amount being $25,000, and that these amounts are material. A conservative estimate would be $30,000, thus showing the lowest amount (of a range of possible values) in the balance sheet for net receivables and the highest expense (and therefore the lowest net income) in the income statement.

However, financial accounting information users could just as easily be misled by a conservative estimate as by an optimistic one. If $25,000 is the best estimate of anticipated bad debts, then that is the number that should be used. Conservatism is not a desirable characteristic nor is it an accounting principle. Nevertheless, there seem to be some accounting practices, such as the lower-of-cost-or-market method for measuring inventory (Chapter 9), that appear to be generated by a desire to be conservative. However, these practices are motivated by other accounting principles such as the realization principle as discussed later in this chapter. They also are influenced by practical realities of our legal system. Investors and creditors who lose money from stock purchases or loans are less likely to sue when bad news is exaggerated and good news is underestimated. While recognizing the role that conservatism plays in how information is reported, we also need to emphasize that it is not a desired characteristic from a qualitative standpoint. Instead, conservatism is a practical constraint on the extent to which other qualitative characteristics are instilled in accounting information.

Now that we’ve discussed the qualities that the elements of financial statements should possess, let’s look more closely at the elements themselves.


30 “Disclosures about Segments of an Enterprise and Related Information,” Statement of Financial Accounting Standards No. 131 (Norwalk, Conn.: FASB, 1997). The contents of this standard are described in the appendix to Chapter 3.
31 “Materiality,” Staff Accounting Bulletin No. 99 (Washington, DC: SEC, August 1999).
32 The FASB’s hierarchy of qualitative characteristics does not specifically identify conservatism as a constraint. Most theorists include conservatism as one of the underlying accounting principles that guide accounting practice. Our classification recognizes its very real role in accounting choices as well as the practical motivation for those choices.








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