I recently published this article with my colleagues Drs. Abraham Fried and Aliza Rotenstein about revenue recognition for gift cards in Journal of Accountancy:
Accounting information is material if its omission or misstatement would mislead investors. In other words, if there’s a piece of information that investors need to know, then that information is material – it makes a difference.
Information can be material in size or importance. In size, materiality is all about the amount. A large amount of money – relative to the size of the company – is material. A small amount of money – relative to the size of the company – is not material. For example, some companies round their financial statement figures to the nearest thousand dollars (or even million dollars). They state a $500,000 expense as $500 “in thousands.” These companies do not consider amounts less than a thousand dollars to be material.
Some items may be small in amount, but large in importance. For example, suppose that the president of the company had a $500 expense which in dollar amount was not material. What was the expense? She bribed a public official. Since this expense is illegal, it is considered material, even though the amount itself is not material.
Why is materiality important? Because accountants don’t want to overload investors with too much information that would confuse them and distract them from what is most important.
Entrepreneurs need to remember not to sweat the small stuff – focus on that portion of your business that generates the most return, and don’t waste too much time on tasks that add little or no value.
In accounting, information has confirmatory value when it helps users to confirm or adjust prior expectations. But why is confirmatory value an important attribute for accounting information to have?
The importance of confirmatory value
People read accounting financial statements in order to create predictions about the future. They want to predict future dividends and that the company will be able to make interest and principal payments. To make these predictions, they often make predictions about future net income. The value of information in making predictions is called predictive value. This information can then be used to make investment decisions. If you predict that a company’s income will rise significantly in the future, then perhaps it is a good investment. Similarly, if you predict that a company won’t be able to pay interest on its bonds next year, then you probably should not invest in its bonds.
Understanding confirmatory value
Here is an analogy. How does a marksman learn to hit a target? With practice. Take a shot. How close to the bulls eye did you get? Take another. Was that better? And another. A good marksman will need many many hours of practice to learn how to shoot.
The same goes for financial analysts. A financial analyst is constantly making predictions, and then – after the fact – gauging their accuracy. Make a prediction. Then see what happened. Make another prediction. How close to the bulls eye did you get? Try again, and again. Confirmatory value is the value of information to gauge how accurate your predictions are – so that you can make more accurate decisions in the future.
Making business decisions
After you make a business decisions, follow up a few weeks later to see what happened. Was it a good decision? An error? Did you hit your target? What could you do next time to make a smarter decision?
Accounting information is relevant (“accounting relevance”) when it is capable of making a difference in a decision.
Suppose that you’re trying to decide what to eat for dinner: A hamburger? Or a salad? What information is relevant to your decision? The price of each meal, perhaps. And consider the number of calories, too. Do you have the food ready to make, or do you need to run to the store? All of this accounting relevance will help you to decide what to eat.
On the other hand, some information is not relevant. You decided to wear blue shoes today. Not relevant.
In accounting, information is used to make investment decisions – and investors who use that accounting information are interested in predicting future income, interest payments, principal payments, and dividend payments. Accounting relevance helps them to make these decisions, while irrelevant information does not. Here are three specific attributes of relevant information:
- Relevant information has predictive value. It helps investors to predict what will happen in the future.
- Relevant information has confirmatory value. It helps investors to assess the predictions, and therefore to improve their skills at making predictions.
- Relevant information is material. If you didn’t know about it, you might make a mistake.
In accounting, information has predictive value when you can use it to form expectations about the future.
Using the future to predict the past
How should investors make decisions about loaning money to a company, or investing in its stock? High quality accounting information helps investors to make these decisions. When you think about it, investors really want to predict the future. Predicting future dividends would assure you that if you buy this stock, you will receive a reasonable payoff. Predicting future interest and principal payments would assure you that you can safely loan a company money.
Here’s the hitch: while you want to know about the future, financial statements only tell you about the past. You have to use last year’s income statement and balance sheet in order to figure out what is likely to happen in the future – the prospects of paying dividends, interest, and principal in the future. That is predictive value.
How to use predictive value
Financial statements have predictive value when they help you to predict the future. For example, to estimate future dividends, or the likelihood of interest and principal being paid to you on time, look for trends that have occurred in the past. If dividends seem to increase by 5% each year over the past five years, then it could be safe to say that they will also increase by 5% next year. On the other hand, if dividends trend in a zig-zag fashion, increasing in some years and decreasing in others, then your information has little predictive value – and it will be difficult for you to predict what happens next.
You can perform similar techniques for other aspects of a company’s performance, such as revenues. Do revenues steadily increase each year (predictive value) or do they zig-zag in an unpredictable way?
The economic entity assumption is one of four assumptions underlying financial statements. It says that you can identify economic activity with a particular unit of accountability.
Put another way, the economic entity assumptions says that certain transactions are “inside” a business, while other transactions are “outside” of the business. Suppose that you run a candy store. Buying candy in order to resell it is “inside” of your business. Your intent is to earn a profit. On the other hand, buying candy in order to eat it is “outside” your business – your intent is to eat candy.
In taxes, a businessperson must be very careful to segregate personal expenses (“outside” the business) from business expenses (“inside” the business). Taxing authorities do not like when businesses deduct personal expenses. Ask Dennis Kozlowski.
Many businesses are actually combined “groups” of businesses. A corporation might own several dozen other corporations, each representing a different line of business. Each corporation may be its own economic entity, reporting its own financial statements. The combined group of corporations may also be an economic entity, reporting its own financial statements.
However, the majority of the people who use Excel, even on a regular basis, happen to be unaware of some options, methods, and general features that the application possesses . These can boost productivity and make life a lot more easier when working on lengthy spreadsheets. Take a look at these tips to speed up your Excel tasks:
Top 5 TipsThere are many hidden features in Microsoft Excel that are not well known. These features can prove to be highly beneficial. Here are the top five tips that we found to improve productivity and functionality when using Microsoft Excel:
• Tip 1: Using Excel Functions in a Jiffy (Even the Unknown Ones)
This tip tells you how to quickly find and apply the formula that you need at the click of a button. Clicking on the Insert Function button is the simplest way to get things started. This button can be found as an “Fx” symbol on the toolbar. Clicking on it allows the user to not only apply a function, but also to search for one in a list or in a categorized format.
Once you find the right formula, summon a wizard to make the process of applying the formula that much easier.
• TIP 2: Using the IF Statement in an Easier Way
The IF statement is one of the most commonly used conditional qualifiers in Excel. It allows the cell to contain content based on the validation of some previous entity. This function may be used in the simple IF(if this condition is true, then return this, or else do this) format of usage, but also other ways for more complex conditions and for multiple conditions too, such as : IF(XYZ(C1<=0,C2>=20),”Yes”,”No”).
• TIP 3: Dealing with Multiple Worksheets
When working on an Excel document that contains multiple worksheets, we have often felt the need to compare the content of both sheets. Very few people know that there is an option to do this automatically. In the View tab, click on “new window”, and the click on “Arrange All>Tiled”, we can tile the sheets side by side.
• TIP 4: Comments for Specific Cells
Often, when working on documents that may change several hands, we find the need to define the content of specific cells in the worksheet, or add information that may be needed for others to effectively contribute to the document. In such cases, the document validation option can be used. With this option, a default value can be made to appear in the cell at all times if the cell content is not correctly added, or is wrongly formatted.
• TIP 5: Hide Unnecessary Content
Hiding data that is not necessary to be visible to users is now quite easy, thanks to grouping. To group and hide unnecessary columns, all that the user has to do is chose the columns needed to be hidden, and select “Group” from the data ribbon. The grouped columns then can be hidden or made viewable by the click of a button, on the outline.
I’m excited to introduce the fourth video in my series explaining how to use to Excel. Learn to format your cells with different fonts. How to get your cell widths and heights right. And how to format numbers and dates. In 10 minutes you can learn all this, and more. Did I mention it’s free?
This video explains how to use references, operators and formulas in Excel. Look out Francis Ford Coppola:
Here’s the whole series, so far:
Part 1: http://youtu.be/HPLuvEL3fNw
Part 2: http://youtu.be/ckoxo6xCvik
Part 3: http://youtu.be/DjOuAO1GDy8
With great multimedia fanfare comes Part 2 of my new Excel series:
Here are all the videos available so far:
Part 1: http://youtu.be/HPLuvEL3fNw
Part 2: http://youtu.be/ckoxo6xCvik
Part 3: http://youtu.be/DjOuAO1GDy8