- Identify other guiding principles of GAAP
In addition to historical cost principles and the monetary unit assumption, economic entity and going concern assumptions, and principle of full disclosure, there are several other guiding principles that the FASB takes into consideration when creating or modifying GAAP, that include:
- Relevance: Is the change useful to existing and potential investors, creditors, and other users in making rational investment, credit, and similar decisions?
- Reliability: The company financial statements provided by the accountants should be based on objective evidence (like historical cost instead of fair market value).
- Consistency: The company uses the same accounting principles and methods from period to period.
- Conservatism: When choosing between two solutions, the solution that has a less favorable outcome is the solution that should be chosen.
- Materiality: 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.
Relevance, Reliability, and Consistency
To be useful, financial information must be relevant, reliable, and prepared in a consistent manner. Relevant information helps a decision-maker understand a company’s past performance, present condition, and future outlook so that informed decisions can be made in a timely manner.
Reliable information is verifiable and objective. For instance, using the original purchase cost of a vehicle per the invoice and payment is objective (not based on opinion) and can be verified by simply looking up the original purchase documents. In other words, two reasonable people looking at the same information should come to the same conclusion.
Consistent information is prepared using the same methods each accounting period, which allows meaningful comparisons to be made between different accounting periods and between the financial statements of different companies that use the same methods. For instance, if a company chooses to report inventory at “lower of cost or market” in its first year in operation, it should continue that method in subsequent years.
The conservatism principle requires that losses be recognized as soon as they can be quantified and gains recorded only when they are realized. This principle protects the users of financial information from inflated revenue, profit, or asset numbers, and also makes potential costs, losses, or declines in value apparent as soon as possible.
Inventory bought for $1,000 can now be purchased for $600. Under the GAAP “lower of cost or market rule,” the company must immediately write down the value of the inventory to $600, showing a loss on the income statement. However, if that inventory item was bought for $1,000 and now would cost the company $1,400, it is still shown as $1,000 on the books. The gain is reflected only when the item sells.
The materiality principle states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information. Certainly, tracking individual paper clips or pieces of paper is immaterial and excessively burdensome to any company’s accounting department, or if the bank balance is off by $0.01, it would cost more to track it down than the additional value of the information would be worth. Although there is no definitive measure of materiality, the accountant’s judgment on such matters must be sound. A hundred or even a thousand dollars may not be material to billion-dollar companies like Monsanto or Facebook, but that same figure may be quite material to a sole-proprietorship with less than $100,000 in annual revenues.
General Electric’s 2019 Financial Statements
For example, from the section on full disclosure, we saw this footnote from General Electric’s December 31, 2019, financial statements:
NOTE 13. POSTRETIREMENT BENEFIT PLANS
PENSION BENEFITS AND RETIREE HEALTH AND LIFE BENEFITS.
We sponsor a number of pension and retiree health and life insurance benefit plans that we present in three categories, principal pension plans, other pension plans, and principal retiree benefit plans. Smaller pension plans with pension assets or obligations less than $50 million and other retiree benefit plans are not presented.
GE’s total revenues were almost $100 billion and total assets were over $266 billion, so $50 million is a relatively small amount for GE. For comparison’s sake, assume you have assets (say, a home, a car, some cash, and other items) worth $266,000 and the bank asked you for a list of your assets. The relative amount of assets not presented would be $50, which might be the combined value of your dishes and other household goods.
In short, it’s material if it makes a difference in the decision-making process.