Reading: Lesson 5 - Modifying conventions

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 immaterial items in a theoretically incorrect manner simply because it is more convenient and less expensive to do so. For example, they may debit the cost of a wastebasket to an expense account rather than an asset account even though the wastebasket has an expected useful life of 30 years. It simply is not worth the cost of recording depreciation expense on such a small item over its life.

The FASB defines materiality as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement".3 The term magnitude in this definition suggests that the materiality of an item may be assessed by looking at its relative size. A USD 10,000 error in an expense in a company with earnings of USD 30,000 is material. The same error in a company earning USD 30,000,000 may not be material.

Materiality involves more than the relative dollar amounts. Often the nature of the item makes it material. For example, it may be quite significant to know that a company is paying bribes or making illegal political contributions, even if the dollar amounts of such items are relatively small.

Conservatism Conservatism means being cautious or prudent and making sure that assets and net income are not overstated. Such overstatements can mislead potential investors in the company and creditors making loans to the company. We apply conservatism when the lower-of-cost-or-market rule is used for inventory. Accountants must realize a fine line exists between conservative and incorrect accounting.

The next section of this Unit discusses the conceptual framework project of the Financial Accounting Standards Board. The FASB designed the conceptual framework project to resolve some disagreements about the proper theoretical foundation for accounting. We present only the portions of the project relevant to this text.