Optional: the ideas behind the rules¶
This section is optional background: the exam will only test the vocabulary in the checklist at the end, not the discussion that leads up to it. It's still worth five minutes, because it explains where the rules in the rest of this course actually come from. GAAP isn't a random list of requirements. It's built to serve one goal, and every rule you'll learn traces back to it.
Why financial reporting exists¶
The objective of financial reporting is to give present and potential investors and creditors information that's useful for deciding whether to put money into a company or lend it money. That's it. Not to help managers run the business day to day, and not to calculate taxes. Those jobs use accounting information too, but they're not what financial reporting is built for.
Example
A bank deciding whether to lend Marlow Landscaping $40,000 for a new truck fleet reads Marlow's financial statements first. The statements exist so that decision can be made without the bank needing to inspect Marlow's shop in person.
What makes information decision-useful¶
Two characteristics are fundamental, meaning information without them isn't useful no matter what else it has going for it. Four more are enhancing: they make already-useful information even better, but they can't rescue information that lacks the fundamental two.
| Characteristic | In one sentence | Tiny example |
|---|---|---|
| Relevance (fundamental) | The information could actually change a decision. | A lender cares about Marlow's cash balance; Marlow's favorite paint color wouldn't change the loan decision. |
| Faithful representation (fundamental) | The information is complete, neutral, and free of material error, matching what really happened. | If Marlow's books show $12,000 of revenue, $12,000 of service was actually delivered, not a number picked to look good. |
| Comparability (enhancing) | Using consistent methods lets you compare one company across years, or two companies against each other. | Marlow and a competing landscaper both depreciate their trucks the same way, so investors can compare the two companies' expenses directly. Using the same method year after year within one company is called consistency, the within-company version of the same idea. |
| Verifiability (enhancing) | An independent person could check the number and get the same result. | An auditor can recount Marlow's supplies on hand and match the amount on the books. |
| Timeliness (enhancing) | The information reaches decision-makers while it can still affect their decisions. | A quarterly report released three weeks after quarter-end is more useful than one released ten months later. |
| Understandability (enhancing) | The information is organized clearly enough for someone with reasonable business knowledge to follow it. | Grouping accounts into assets, liabilities, and equity helps a first-time reader make sense of the balance sheet. |
The assumptions and the constraint behind the numbers¶
A handful of ground-rule assumptions make the whole system work. The economic entity assumption treats a business's finances as separate from its owners' personal finances, even for a small corporation, so a stockholder's personal car loan never shows up on the company's books. The going concern assumption treats the business as continuing to operate for the foreseeable future, rather than assuming it's about to shut down and sell everything off. The periodicity assumption lets a business's continuous life be chopped into artificial slices, quarters and years, so people don't have to wait until a company closes its doors to get any information. The monetary unit assumption measures everything in dollars and treats the dollar as stable enough to add together across time. That's why a truck bought in 2020 and one bought this year both show up as dollar amounts on the same balance sheet.
One more idea limits all of this: the cost constraint. A rule only makes sense if the benefit to users of the information is worth more than the cost of producing it. That's why companies aren't required to track every possible detail, and it's why smaller and private companies get simplified versions of some requirements.
The next section pulls the whole chapter together into a working summary and a set of practice problems.
Before you go on¶
You don't need to reconstruct the discussion above, just recognize these terms and what they mean:
- Objective of financial reporting (useful to investors and creditors)
- Relevance
- Faithful representation
- Comparability
- Verifiability
- Timeliness
- Understandability
- Economic entity assumption
- Going concern assumption
- Periodicity assumption
- Monetary unit assumption
- Cost constraint