Gift Card Accounting

Companies record gifts cards sold as liabilities, because ultimately they will need to redeem the gift cards and provide products or services to customers.

Here is a link to my article about revenue recognition for gift cards in Journal of AccountancyLost and found.


Managing Materiality

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 and therefore material. 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.


Understanding confirmatory 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 decision, 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?


Relevance in accounting

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 number of calories? The price of each meal, perhaps? 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:

  1. Relevant information has predictive value. It helps investors to predict what will happen in the future.
  2. Relevant information has confirmatory value. It helps investors to assess the predictions, and therefore to improve their skills at making predictions.
  3. Relevant information is material. If you didn’t know about it, you might make a mistake.

When does accounting information have “predictive value?”

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?


What is the economic entity assumption?

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 subsidiary a different line of business. Each subsidiary may be its own economic entity, reporting its own financial statements. The combined group of subsidiary may also be an economic entity, reporting its own financial statements.


My new Introduction to Excel (YouTube)

I’m proud to announce the first video of my Introduction to Excel series. This series is designed to give you the basic tools you need to get up and running in Microsoft Excel.

Here are the videos released so far:

Part 1:

Part 2:

Part 3:

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