Page 208 - Accounting Principles (A Business Perspective)

5. Accounting theory

Losses consume assets, as do expenses. However, unlike expenses, they do not produce revenues. Losses are
usually involuntary, such as the loss suffered from destruction by fire on an uninsured building. A loss on the sale of
a building may be voluntary when management decides to sell the building even though incurring a loss.

The full disclosure principle states that information important enough to influence the decisions of an
informed user of the financial statements should be disclosed. Depending on its nature, companies should disclose
this information either in the financial statements, in notes to the financial statements, or in supplemental
statements. In judging whether or not to disclose information, it is better to err on the side of too much disclosure
rather than too little. Many lawsuits against CPAs and their clients have resulted from inadequate or misleading
disclosure of the underlying facts.
We summarize the major principles and describe the importance of each in Exhibit 29.

An accounting perspective:

Business insight

The accounting model involves reporting revenues earned and expenses incurred by the company.
Some have argued that social benefits and social costs created by the company should also be
reported. Suppose, for instance, that a company is dumping toxic waste into a river and this action
causes cancer among the citizens downstream. Should this cost be reported when preparing
financial statements showing the performance of the company? What do you think?

Modifying conventions (or constraints)
In certain instances, companies do not strictly apply accounting principles because of modifying conventions (or
constraints). Modifying conventions are customs emerging from accounting practice that alter the results
obtained from a strict application of accounting principles. Three modifying conventions are cost-benefit,
materiality, and conservatism.
Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including optional

information in financial statements exceed the costs of providing the information. Users tend to think information
is cost free since they incur none of the costs of providing the information. Preparers realize that providing
information is costly. The benefits of using information should exceed the costs of providing it. The measurement of
benefits is inexact, which makes application of this modifying convention difficult in practice.
Materiality Materiality is a modifying convention that allows accountants to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner. The fundamental question accountants
must ask in judging the materiality of an item is whether a knowledgeable user's decisions would be different if the

information were presented in the theoretically correct manner. If not, the item is immaterial and may be reported
in a theoretically incorrect but expedient manner. For instance, because inexpensive items such as calculators often
do not make a difference in a statement user's decision to invest in the company, they are immaterial (unimportant)
and may be expensed when purchased. However, because expensive items such as mainframe computers usually do
make a difference in such a decision, they are material (important) and should be recorded as assets and
depreciated. Accountants should record all material items in a theoretically correct manner. They may record

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