2.1 Creating a Portrait of an Organization That Can Be Used by Decision Makers
At the end of this section, students should be able to meet the following objectives:
- Explain the comparison of financial accounting to the painting of a portrait.
- Understand the reasons why financial accounting information does not need to be exact.
- Define the term “material” and describe its fundamental role in financial accounting.
- Define the term “misstatement” and differentiate between the two types of misstatements: errors and fraud.
Financial Statements: The Portrait of an Organization
Question: In Chapter 1 "What Is Financial Accounting, and Why Is It Important?", mention was made that financial accounting is somewhat analogous to the painting of a giant, complex portrait. How could financial accounting possibly be compared to an artistic endeavor such as the creation of a painted portrait?
Answer: The purpose of a portrait—as might have been created by Rembrandt, van Gogh, or even Picasso—is to capture a likeness of the artist’s model. In a somewhat parallel fashion, financial accounting attempts to present a portrait of an organization that can be used by interested parties to assess its financial health and future prospects. If well painted, this picture should enable individuals to estimate future stock prices, dividend payments, and cash flows. Accounting even has specific terms (such as representational faithfulnessA reasonable agreement between reported information and the event or balance it purports to represent; this term refers to the communication of an appropriate picture of an organization, which can serve as the basis for appropriate decisions. and presents fairlyFinancial information that contains no material misstatements in accordance with an accepted standard for financial reporting.) that are used to indicate that financial information successfully provides a reasonable likeness of the reporting organization.
In accounting, this portrait is most often presented in the form of financial statementsQuantitative reports and related verbal disclosures that convey monetary information describing the operations, financial position, and cash flows of an organization as a basis for representing its financial health and future prospects.. The accountant takes all appropriate monetary information and constructs a set of financial statements to be distributed to decision makers. Financial statements are a representation of an organization’s operations, financial position, and cash flows. These statements provide the form and structure for the conveyance of financial information that will create a likeness of the reporting organization. This textbook is about the preparation of those financial statements and the meaning of their contents.
A Likeness Does Not Have to Be Exact
Question: Financial accounting deals with numbers that are exact. A 3 is a 3 and nothing else. In describing the production of financial statements, why are the results not compared to a photograph rather than a painted portrait? After all, a photograph is a much more precise likeness than a painting.
Answer: A human portrait, even by a master such as Rembrandt, will not be completely accurate. The shape of the person’s chin or the turn of the neck may be off slightly. The color of the eyes and hair cannot possibly be a perfect replica of life. It is a painted portrait, not a photograph (which is much more mechanically accurate). Fortunately, absolute exactness is not necessary for capturing the essence of a model. A likeness is achieved when a viewer exclaims, “I know that person!” Exact precision is not required to meet that objective.
Despite public perception to the contrary, financial accounting information is rarely an exactly accurate portrait. The accountant’s goal is to create financial statements that present a likeness of an organization that can be used to make decisions. For example, the reported cost of constructing a building may be off slightly because of the sheer volume of money being spent on the many different aspects of the project. No one expects the reported cost of a $50 million manufacturing plant to be accurate to the penny. As with the painted portrait, that does not necessarily reduce the usefulness of the data. If financial information provides a fair representation, an interested party should be able to make use of it to arrive at the desired projections such as future stock prices. A potential investor or creditor does not need numbers that are absolutely accurate in order to assert, “Based on the information available in the financial statements, I understand enough about this business to make informed decisions. Even if I could obtain figures that were more accurate, I believe that I would still take the same actions.”
An artist applies oil paints, pastels, or watercolors to a canvas to present a likeness of a subject. An accountant does something quite similar in constructing financial statements with numbers and words. The goal is much the same: to produce a likeness that truly reflects the essence of the model, which, in this case, is an entire organization.
For the year ending January 31, 2011, Walmart reported having made sales to its customers (net of returns and allowances) of $418,952,000,000. James Forrest is studying the available information in order to decide whether to buy ownership shares of Walmart on the New York Stock Exchange at the current price. Which of the following statements is true about the figure reported as the company’s net sales?
- Walmart made net sales during these twelve months of exactly $418,952,000,000.
- The $418,952,000,000 is accurate, although the number has been rounded to the nearest million.
- Net sales were probably not $418,952,000,000 for the year, but that figure is close enough to be a fair presentation, one that Forrest can rely on in making his decision.
- If this net sales figure had not been correct, Walmart’s accountants would not have allowed the company to report the amount.
The correct answer is choice c: Net sales were probably not $418,952,000,000 for the year, but that figure is close enough to be a fair presentation, one that Forrest can rely on in making his decision.
Accounting data are rarely accurate. That degree of exactness is often impossible to achieve and is not required when assessing a company’s financial health. Financial statements are created to provide a fair presentation. Forrest ultimately wants to estimate stock prices and dividend payments. Net sales were almost certainly not as reported, but any difference between this number and the actual amount is not expected to be large enough to have an impact on the decisions that will be made.
Question: This is a surprising, possibly shocking, revelation. Financial accounting information has universally been branded as exhibiting rigid exactness. In fact, accountants are often referred to as “bean counters” because of their perceived need to count every bean in the bowl to arrive at obsessively accurate numbers. Here, though, the assertion is made that accounting information is not a precise picture but merely a fair representation of an organization’s financial health and future prospects. How correct or exact is the financial information that is reported by a business or other organization?
Answer: In financial accounting, the data presented to decision makers by an organization should never contain any misstatementsErrors or frauds that cause reported financial information to differ from the approach required by an official standard for reporting such as the U.S. Generally Accepted Accounting Principles (U.S. GAAP) or International Financial Reporting Standards (IFRS). that are deemed to be materialThe magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by that omission or misstatement.. This basic standard has long served as the required level for accuracy in financial reporting. Decision makers want financial statements—such as those prepared by Starbucks or Intel—that they can trust and use. That requires the statements to be free of any material misstatements. In that condition, reported financial information will be viewed as a likeness of the organization that is presented fairly. Thus, financial statements do not need exact accuracy. However, they must be free of material misstatements in order to be of use to decision makers.
A misstatement is an errorAn unintentional misstatement of financial information. (made accidentally) or fraudAn intentional misstatement of financial information; it can result from misappropriation of assets (theft) or fraudulent financial reporting. (done intentionally) where reported figures or words actually differ from the underlying reality. In simple terms, the information is wrong.
For example, a corporate official could erroneously record a $100,000 expenditure that was made in connection with the construction of a new building as if it pertained to the purchase of land. Consequently, the building’s cost might be reported as only $2.3 million when it was actually $2.4 million. This reported number is misstated; it is wrong. The balance presented for the building contains a $100,000 error, as does the figure shown for land. This misstatement, though, might not be viewed as material.
A misstatement is deemed to be material if it is so significant that its presence would impact a decision made by an interested party. Using the previous illustration, assume the accidental $100,000 reduction in the reported cost of this building leads an outside decision maker to alter a choice being made (such as whether to buy or sell the business’s capital stock or whether to grant a loan). Because of the change in the decision, the misstatement is judged to be material by definition. If no decision is affected, a misstatement is not material, and its existence does not prevent the reported information from still being fairly presented. The reported information is usable for decision making.
Financial information can (and almost always does) contain misstatements. However, the reporting entity must take adequate precautions to ensure that reported information holds no material misstatements for the simple reason that it is no longer fairly presented. If any material misstatements exist within the information, the portrait of the organization is not a proper likeness of the model. The decision maker is being misled.
The concept of materiality can seem rather nebulous. For the financial statements of a small convenience store, a $10 misstatement is not material whereas a $10 million one certainly is. For a business with real estate holdings of $30 billion, even a $10 million misstatement is probably not material. The problem for the accountant is determining where to draw the line for a particular organization. That is one of the most difficult decisions for any financial accountant. An exact dollar amount for materiality is virtually impossible to identify because it is a measure of the effect of a misstatement on an external party’s judgment.
Other than sheer magnitude, the cause of the problem must also be taken into consideration. An accidental mistake of $100,000 is less likely to be judged material than one of $100,000 that resulted from a fraudulent act. Fraud occurs when someone wants to misrepresent reported numbers to make the organization look differently than it is or to cover theft. Fraud includes the intent to deceive and is more troublesome to decision makers than a mere error. Thus, both size and cause should be weighed in considering whether the presence of a misstatement has the ability to impact the actions of any decision makers.
Consequently, a financial accountant never claims that reported information is correct, accurate, or exact. Such precision is rarely possible and not needed when decision makers are analyzing the financial health and future prospects of an organization. However, the accountant must take all precautions necessary to ensure that reported data contain no material misstatements. Financial figures are never released without reasonable assurance being obtained that no errors or other mistakes are included that could be material, or in other words, that could impact the decisions that are made. All parties need to believe that reported information can be used with confidence because it presents a fair likeness of the organization as a whole.
When a company reports that a building was constructed at a cost of $2.3 million, the real message is that the actual cost was not materially different from $2.3 million. This figure is a fair representation of the amount spent, one that can be used in making decisions about the organization such as whether to invest in its capital stock or provide it with a loan.
For the year ending January 31, 2011, Walmart reported earning net income of $16,389,000,000. Which of the following statements is not true?
- Net income is probably not $16,389,000,000, but it is not materially different than the reported figure.
- To aid investors, actual net income could be lower than $16,389,000,000 but should not be any higher.
- Decision makers should feel comfortable making decisions about the company based on this figure.
- With companies of such size, determining an exact net income is impossible.
The correct answer is choice b: To aid investors, actual net income could be lower than $16,389,000,000 but should not be any higher.
Net income reflects a likeness of a company’s earnings that a decision maker can use. With so many complex transactions, precisely accurate figures are impossible. Company officials do need to have sufficient evidence to indicate that net income contains no material misstatements. Accountants tend to be conservative, which is likely to reduce reported income figures. Therefore, actual net income is more likely to be slightly higher than the reported figure rather than lower.
Financial accounting does not attempt to provide exact numbers because such accuracy is often impossible to achieve and not really required by decision makers. Instead, reported accounting information is intended to provide a likeness of an organization and its operations—a type of portrait. To achieve this goal, financial accountants must ensure that reported balances and other data cannot contain any material misstatements. A misstatement is inaccurate information included by accident (an error) or intentionally (fraud). Materiality refers to the point at which the size or the nature of such misstatements would cause a change in the decisions made by an individual using that information. If all material misstatements can be eliminated, the information is considered to be presented fairly. That likeness can then be used by interested parties to make considered decisions.