How Accounting information impacts business decisions
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Information of any sort is relevant if it would influence a decision. Accounting information is relevant if it would make a difference in a business decision. For example, when Colorado Group Ltd issues financial statements, the information in the statements is considered relevant because it provides a basis for forecasting future profits. Accounting information is also relevant to business decisions because it confirms or corrects previous expectations. Thus, Colorado Group Ltd's financial statements help predict future events and provide feedback about previous expectations for the financial health of the company. The relevance of information is affected by its materiality. Information is material if its omission or misstatement could affect users' decisions. Information that is immaterial need not be separately identified. For example, if Colorado Group Ltd sold a coathanger for $1 this would be considered immaterial; the sale would be recorded in the accounting records although it would not be separately identified in the financial statements.
Reliability of information means that the information can be depended on. To be reliable, accounting information must be without undue error. Also, the information must be a faithful representation of what it purports to be. If an entity's financial statements report sales of $20 million when it actually had sales of $10 billion, then the statements are not a faithful representation of the entity's financial performance. Accounting information must be neutral, that is, unbiased - it must not be selected, prepared or presented to favour one set of interested users over another.
To be reliable, information must also be complete. Further. If information is to faithfully represent transactions and events, it is necessary to account for those transactions and events according to their substance and economic reality, rather than only considering their legal form. For example, if the entity transfers ownership of an asset but continues to enjoy the benefits of ownership, accountants do not always recognize it as a sale. Reliability also incorporates prudence, that is, caution not to overstate income and assets, or to understate expenses and liabilities.
Let's say that you and a friend kept track of your height each year as you were growing up. If you measured your height in feet and your friend measured hers in centimeters, it would be difficult to compare your heights. A conversion would be necessary. In accounting, comparability results when different entities use the same accounting principles.
At one level, accounting standards are fairly comparable because they are based on certain qualitative characteristics, basic principles and assumptions. However, standards still allow for some variation in methods. For example, there are different ways to measure inventory/goods held for sale. Often these different methods result in different amounts of profit. To make comparison across entities easier, each entity must disclose the accounting methods used. From the disclosures, the external user can determine whether the financial information is comparable and try to make adjustments. Unfortunately, converting the accounting numbers of entities that use different methods is not as easy as converting your height from feet to centimeters.
One factor that can affect the ability to compare two entities is their choice of balance date. Most entities choose 30 June as their balance date, but other dates are also used. For example, look at Colorado Group Ltd's balance date. Retailers often use balance dates that coincide with the end of a week. However, this practice results in some years having 52 weeks whereas in other years (and for other entities) financial statements may be for a 53-week period.
Users of accounting information also want to compare the same entity's financial results over time. For example, to track Colorado Group Ltd's profit over several years, you would need to know that the same principles have been used from year to year; otherwise, you might be 'comparing apples with oranges'. Comparability is not satisfied unless an entity uses the same accounting principles and methods from year to year. Thus, if an entity selects one inventory accounting method in the first year of operations, it is expected to continue to use that same method in succeeding years. When financial information has been reported on a consistent basis, the financial statements permit meaningful analysis of trends within an entity.
An entity can change to a new method of accounting if management can justify that the new method produces more meaningful financial information or if it is required by a change in accounting standards. In the year in which the change occurs, the change must be disclosed so that users of the statements are aware of the lack of consistency.
Information contained in general-purpose financial reports should also be understandable. But whether information is understandable depends on the capabilities of the individual user. In maintaining this qualitative characteristic, preparers should be mindful of users of general-purpose financial reports who have the proficiency to comprehend the significance of accounting practices, i.e. users who understand the effect of alternative accounting methods on financial statements. It is not practical to require financial statements to be understandable to novices. Entitles often need to report on complex transactions that cannot always be simplified to the extent that someone with no knowledge of accounting could understand them.