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even though historical cost is reliable, reporting the current market value of the property would be more relevant--but also less reliable.
Consider also derivative instruments, an area where relevance trumps reliability. Derivatives can be complicated and difficult to value, but some derivatives (speculative not hedge derivatives) increase risk. Rules therefore require companies to carry derivatives on the balance sheet at "fair value", which requires an estimate, even if the estimate is not perfectly reliable. Again, the imprecise fair value estimate is more relevant than historical cost. You can see how some of the complexity in accounting is due to a gradual shift away from "reliable" historical costs to "relevant" market values.
The second reason for the complexity in accounting rules is the unavoidable restriction on the reporting period: financial statements try to capture operating performance over the fixed period of a year. Accrual accounting is the practice of matching expenses incurred during the year with revenue earned, irrespective of cash flows. For example, say a company invests a huge sum of cash to purchase a factory, which is then used over the following 20 years. Depreciation is just a way of allocating the purchase price over each year of the factory's useful life so that profits can be estimated each year. Cash flows are spent and received in a lumpy pattern and, over the long run, total cash flows do tend to equal total accruals. But in a single year, they are not equivalent. Even an easy reporting question such as "how much did the company sell during the year?" requires making estimates that distinguish cash received from revenue earned: for example, did the company use rebates, attach financing terms, or sell to customers with doubtful credit?
(Please note: throughout this tutorial we refer to U.S. GAAP and U.S.-specific securities regulations, unless otherwise noted. While the principles of GAAP are generally the same across the world, there are significant differences in GAAP for each country. Please keep this in mind if you are performing analysis on non-U.S. companies. )
The Financial Statements Are a System (Balance Sheet & Statement of Cash Flow)
Financial statements paint a picture of the transactions that flow through a business. Each transaction or exchange--for example, the sale of a product or the use of a rented facility--is a building block that contributes to the whole picture.
Let's approach the financial statements by following a flow of cash-based transactions. In the illustration below, we have numbered four major steps:
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