2.2 Dealing with Uncertainty
At the end of this section, students should be able to meet the following objectives:
- Discuss the challenge created for financial accountants by the presence of uncertainty.
- List examples of uncertainty that an accountant might face in reporting financial information about an organization.
- Explain how financial accounting resembles a language, such as Spanish or Japanese.
Uncertainty, the True Challenge for Reporting
Question: Financial accounting figures can certainly be exact. If a cash register is bought for $836.54, the reported cost is $836.54. However, decision makers do not need financial figures with such absolute accuracy. If reported information is presented fairly, in other words if it contains no material misstatements, it can be used to estimate a corporation’s future stock prices, cash dividend payments, and cash flows. Even if not necessary for decision makers, what prevents reported financial information from being correct in an absolute sense? Why are all reported figures not as precise as the reporting of the cash register?
Answer: In truth, a reasonable percentage of numbers reported in a set of financial statements are exact. Materiality is not an issue in such cases. The cash register mentioned here has a reported cost of $836.54—a precise measure of the amount paid. Likewise, a cash balance shown as $2,785.16 is exact to the penny. However, many of the other figures reported by an organization do not lend themselves to such accuracy.
The primary reason that exactness is not a goal—often not even a possibility in financial accounting—can be summed up in a single word: uncertainty. Many of the events encountered every day by an organization contain some degree of uncertainty. Unfortunately, no technique exists to report uncertain events in precise terms.
When first introduced to financial accounting, many students assume that it is little more than the listing of cash receipts and disbursements in much the same way that elementary school children report how they spent their weekly allowances. That is a misconception. Financial accounting is a structured attempt to paint a fairly presented portrait of an organization’s overall operations, financial condition, and cash flows. This requires the reporting of many events where a final resolution might not occur for months or even years. Here are just a few examples of the kinds of uncertainty that virtually every business (and financial accountant) faces in creating financial statements.
- A business is the subject of a lawsuit. Perhaps a customer has filed this legal action claiming damage as a result of one of the company’s products. Such legal proceedings are exceedingly common and can drag on in the courts for an extended period of time before a settlement is reached. The actual amount won or lost (if either ever occurs) might not be known for years. What should the business report now?
- A sale of merchandise is made today for $300 with the money to be collected from the customer in several months. Until the cash is received, no one can be sure of the exact amount that will be collected. What should the business report now?
- An employee is promised a cash bonus next year that will be calculated based on any rise in the market price of the corporation’s capital stock. Until the time passes and the actual increase (if any) is determined, the amount of this bonus remains a mystery. What should the business report now?
- A retail store sells a microwave oven today with a warranty. If the appliance breaks at any time during the next three years, the store has to pay for the repairs. No one knows whether the microwave will need to be fixed during this period. What should the business report now?
Any comprehensive list of the uncertainties faced regularly by most organizations would require pages to enumerate. Many of the most important accounting rules have been created to establish requirements for the reporting of uncertain situations. Because of the quantity and variety of such unknowns, exactness simply cannot be an objective of financial reporting.
For many accountants, dealing with so much uncertainty is the most interesting aspect of their job. Whenever an organization encounters a situation of this type, the accountant must first come to understand what has happened and then determine a logical method to communicate a fair representation of that information within the framework provided by financial accounting rules. Thus, reporting events in the face of uncertainty is surely one of the major challenges of being a financial accountant.
Accounting as the Language of Business
Question: Accounting is sometimes referred to as the “language of business.” However, in this book, financial accounting has already been compared to the painting of a fairly presented portrait of an organization. Given the references throughout this chapter to painting, is accounting really a type of language? Is it possible for accounting to paint portraits and also be a language?
Answer: The simple answer to this question is that accounting is a language, one that enables an organization to communicate a portrait of its financial health and future prospects to interested parties by using words and numbers rather than oils or watercolors. The formal structure of that language becomes especially helpful when an organization faces the task of reporting complex uncertainties.
Any language, whether it is English, Spanish, Japanese, or the like, has been developed through much use to allow for the effective transfer of information between two or more parties. If a sentence such as “I drive a red car” is spoken, communication is successful but only if both the speaker and the listener have an adequate understanding of the English language. Based solely on the arrangement of these five words, information can be passed from one person to the another.
This process succeeds because English (as well as other languages) relies on relatively standardized terminology. Words such as “red,” “car,” and “drive” have defined meanings that the speaker and the listener both know with a degree of certainty. In addition, grammar rules such as syntax and punctuation are utilized to provide a framework for the communication. Thus, effective communication is possible in a language when
- Set terminology exists
- Structural rules and principles are applied
As will be gradually introduced throughout this textbook, financial accounting has its own terminology. Many words and terms (such as “LIFO” and “accumulated depreciation”) have very specific meanings. In addition, a comprehensive set of rules and principles has been established over the decades to provide structure and standardization. They guide the reporting process so that the resulting information will be fairly presented and can be readily understood by all interested parties, both inside and outside of the organization.
Some students who read this textbook will eventually become accountants. Those individuals must learn specific terminology, rules, and principles in order to communicate financial information about an organization that is presented fairly. Others (probably most readers) will become external decision makers. They will make financial decisions. They will evaluate loan applications, buy capital stock, grant credit, make employment decisions, provide investment advice, and the like. They will not present financial information with all of its uncertainties but rather they will need to make use of it. The more such individuals know about financial accounting terminology, rules, and principles, the more likely it is that they will arrive at appropriate decisions.
To communicate a portrait properly in any language, both the speaker and the listener must understand the terminology as well as the structural rules and principles. That holds true even if the language is financial accounting.
At any point in time, organizations face numerous uncertain outcomes, such as the settlement of litigation or the collection of a receivable. The conveyance of useful information about these uncertain situations goes beyond the simple reporting of exact numbers. To communicate a fair representation of such uncertainty, financial accounting must serve as a language. Thus, it will have established terminology and structural rules much like that of any language. For successful communication of financial information, both the terminology and the structural rules must be understood by all parties involved.