“go

AJALITATIVE
CHARACTERISTICS

OF ACCOUNTING
INFORMATION

Che FASB states that “relevance and reliability are the two primary gual-
ties that make accounting information useful for decision making.”' Rele-
'ance is defined as the capacity of the inforrnation “to make a difference”
n making a decision by the user, and reliability is defined as the guality. that
ives assurance that the information is reasonably free of error and bias,
ind represents what it purports to represent. As the FASB sees it, a hierar-
hy of gualities exists.? This can be summarized as follows:

Usefulness of information for decision making:

l.

FASB, “

Relevance.

a. Predictive value.
b. Feedback value.
c. Timeliness.

. Reliability.

a. Verifiabiliry.
b. Neutrality.
c. Representational faithfulness.

. Secondary gualities are comparability and consistency which interact with

relevance and reliability.

. Costs and benefits and materiality are constraints on the usefulness of

information.

“Oualitative Characteristics of Accounting Information,” Statement of Financial Ac-

ounting Concepts No. 2, May 1980, in Summary of Principal Conclusions.

Ibid., paragraph 32.

515
516 Chapter 17/@UALITATIVE CHARACTERISTICS OF ACCOUNTING

Because the preceding characteristics are components of the notion of

“useful” information, they can be seen as more descriptive aspects of the
objective of accounting discussed previously in Chapter 2. The APB re-
ferred. to these characteristics as “gualitative objectives.”

RELEVANCE
To be relevant, information must be logically related to a given decision.
The FASB points out that to be relevant to investors, creditors, and others
for investment, credit, and similar decisions, accounting information

must be capable of making a difference in a decision by helping users to form

predictions about the outcomes of past, present, and future events or to confirm
or correct expectations.

# Information is relevant to a decision if it can reduce the uncertainty

about the variables in the decision process. Information about past activi-
ties aids in the prediction of the outcome of related future activities. Exam-
ples given by the FASB are reporting of results by segments, which help
users assess the performance of the segments and predict the trend of
earnings in a diversiffed company, and interim earnings reports, which
provide both feedback on past performance and a basis for prediction of
annual income before the year end. Therefore, relevant information must
have predictive value and/or feedback value. Usually, both are supplied
simultaneously, because knowledge about the conseguences of actioris
taken will improve the decision maker's ability to predict the results of
similar future actions. .

Timeliness is also a component of relevance. If the information is not

available at the time a decision needs to be made, it lacks relevance. The
idea of timeliness is to have information for decision makers before it loses
its capability to influence decisions.

MATERIALITY

The FASB considers materiality to be a constraint on both relevance and

reliability, although it admits that the former has much in common with
materiality.? Materiality is primarily related to relevance. If an item is not
material, then it is not relevant.

3APB, “Basic Concepts and Accounting Principles Underlying Financial Statements of Busi-
ness Enterprises,” Statement No. 4, October 1970, paragraph 85.

“FASB Concepts Statement 2, paragraph 47.

?FASB Concepts Statement No. 2, paragraph 125.
MATERIALITY Sig

From a positive perspective, materiality has to do with the sigrnificance of

an item Or event to warrant attention in the accounting process, because the
information is deemed to be important to the user in his decision tnaking.
From a negative viewpoint, materiality is critical because otherwise a great
deal of time might be spent on trivial matters in the accounting process. or
the amount of data presented to users in the financial statements night be
s0 large that important information might be obscured. Put another wav,
the concept of materiality boils down to this: “L£ it doesn't really matter.
don't bother with it.”

Materiality Guides by Authoritative Bodies

With respect to the financial statements that must be filed with it, the SEC
states that if an amount is “not material, it need not be separately set
forth.” It defines materiality in terms of the information that “an average
prudent investor ought reasonably to be informed.”? Occasionally, it has
provided specific guantitative guidelines. For example, it reguires disclo-
sure of the following: certain costs and expenses that exceed 1 percent of
total sales and revenue: certain items on the balance sheet if 10 percent or
more of their category or more than 5 percent of total assets: a receivable
from an officer or principal shareholder if the amount is $20,000 or more,
or 1 percent of total assets.

The APB in Statement No. 4 mentioned that financial reporting is only

concerned with “significant information.”? It found it necessary to estab-
lish specific guantitative criteria for given situations. The following are
examples:

Opinion 15 on earnings per share. A reduction of less than 34 in the aggregate

need not be considered as dilutive in computing earnings per share.

Opinion 16 on business combinations. Conditions for pooling of interests

method include the following: cach of the combining companies hold no more
than 1096 of the outstanding voting common stock of the other on the date of the
plan: the exchange of stock must be for at least 909 of the voting stock of the
combined company.

Opinion 17 on intangible assets. The period of amortization is not to exceed 40

years.

Opinion 18 on the eguity method. An investment of 209 or more of the voting

stock leads to the presumption of significant influence.

9Walter Meigs, Principles of Auditing (Irwin, 1959), p. 14.

'SEC Regulation S-X, Rule 3-02.
?SEC Regulation S-X, Rule 1-02.
?APB Statement 4, paragraph 25.
518 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

The APB also mentioned that materiality should be considered in deter

mining the cumulative effect of a change in principle (Opinion 20), and ii
determining that an item is extraordinary (Opinion 30).

The FASB in Concepts Statement No. ? defines materiality as follows

The magnitude of an omission or misstatement of accounting information thai

in the light of surrounding circumstances, makes it probable that the judgmen
of a reasonable person relying on the information would have been changed o
influenced by the omission or misstatement. '"

The FASB has given guantitative guidelines for a number of situations

Examples are:

Statement 13 on leases. Criteria for determining that a lease is a capital leas

include the rule that the lease term is egual to 7595 or more of the economic lif
of the asset, and the rule that present value of the lease eguals or exceeds 90K 0
the excess of the fair value of the asset to lessor over any related investment ta
credit.
Statement 14 on segment reporting. An industry segment is considerei
significant and therefore is to be a reportable segment if it satisfes one of th
following tests:

|. Revenue is 109 or more of combined revenue of all the enterprise's indu:

try segments,
2. Operating profit or loss is 1096 or more of the greater of:
a. the combined operating profit of all industry segments that did nc
incur an operating loss,
b. the combined operating loss of all industry segments that did incur a
Operating loss. “0
3. Identifiable assets are 1095 or more of the combined identifiable assets €
all segments.

Statement 30 on major customers. If 1096 or more of revenue is derived frot

sales to any single customer, that fact and amount shall be disclosed.

Statement 45 on earnings per share. The test for common stock eguivalency fc
convertible securities is based on 66 2/39 of the current average Aa corpora!
bond yield.

Statement 66 on sales of real estate. One of the criteria for use of the full accru:
method is that the cumulative payments of principal and interest egual or exce€
109 of the contract sales price. A down payment of 209 or more is an indicatio
of collectibility of the receivable.

The preceding examiples show that authoritative bodies have found

necessary to present specific guantitative rules, which fall under the heat
ing of materiality. These rules concern the classification of items (e.g

'OFASB Concepts Statement No. 2, Glossary.

MATERIALITY 519

2gment reporting) or the use of a particular method (e.g., eguity vs. cost

'ethod, pooling vs. purchase) or how a calculation is to be made (e.g.,

ommon stock eguivalency for earnings per share) or the recognition of an

sset or liability (for example, capital lease). In other words, authoritative

odies have considered these distinctions to be sufficiently significant to

cessitate the use of specific guantitative guides.

udicial Decisions

'here have been a number of court cases dealing with materiality, but two
re of particular significance and are discussed here. The BarChris case
Iscott et al. v. BarChris Corporation et al., United States District Court, South-
rn District of New York) was a class action suit on behalf of purchasers of
arChris Corporation's convertible subordinate debentures offered.in
961, which had a total maturity value of $3,500,000. In 1968, Judge
IcLean found that a registration statement by the company, which in-
uded a prospectus and consolidated balance sheet, was materially false
nd misleading. Said Judge McLean,
The average prudent investor is not concerned with minor inaccuracies or with
errOrs as to matters which are of no interest to him. The facts which tend to deter
him from purchasing a security are facts which have an important bearing upon
the nature or condition of the issuing corporation or its business.!!

Based on this criterion, Judge McLean found the following items in

961 to be material: overstatement of sales (reported at $2,138,455, an
verstatement of $519,810): overstatement of gross profit for the first
uarter (reported at $483,121: an overstatement of $230,755): understate-
rent of contingent liabilities (reported at $825,000, an understatement of
618,853): overstatement of backlog orders (reported at $6,905,000: an
verstatement of $4,490,000): failure to report outstanding and unpaid
JIvances from officers of $386,619, failure to report delinguencies in cus-
»mer receivables of over $1,350,000.

Other items were not as casily determined io be materially misstated.

adge McLean asked:

Would it have deterred the average prudent investor from purchasing these
debentures if he had been informed that the 1960 sales were $8,511,420 rather
than $9,165,320, that the net operating income was $1,496,196 rather than

$1,742,801 and that the carnings per share in 1960 were approximately $.65
rather than $.75?12

le concluded that the preceding items were not material.

Escott et al. v. BarChris Construction Corporation, 288 F. Supp. 681 (District Court S.D. New
ork, 1968).

Ibid.
520 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

The Herzfeld case (Herzfeld v. Laventhol, Krekstein, Horwath & Horwai

District Court, Southern District New York, 1974) involved the priva
placement in 1969 of securities of the Firestone Group, Ltd. at a price
$7,500,000. Investors charged that the financial statements for the peri
ending November 30, 1969, were materially misleading. The auditor
Laventhol & Horwath, had issued a gualified opinion.

The point at issue centered on the accounting treatment of the purcha

of certain nursing homes for $13,362,500 and their subseguent sale f
$15,393,000. Of the $2,030,500 difference between sales price and co
$235,000 were recorded as curreni income and the balance, $1,795,50
was deferred. The company had received $25,000 as down payment fro
the buyer. Laventhol & Horwath stated that the company's financial stat
ments presented fairly the financial position “subject to the collectibility
the balance receivable on the contract of sale.” It referred to a footnc
where the terms of the purchase and sale and the accounting treatment
the difference were mentioned.

Laventhol & Horwath argued that full disclosure had been mac
whereas the plaintiffs contended that despite the footnote the financ
statements were materially misleading. The court agreed with the plai
tiffs. Judge MacMahon stated that full disclosure of all material facts 1
guired, among other items, disclosure of the following: the purchaser's n
worth, the fact that the president of the purchasing company was n
personally liable on the contracts, the fact that the purchase and subs
guent sale were not recorded in the journal or corporate minutes book, t.
fact that the transaction was the largest for the company, the fact that t
company would have shown a loss of $169,000 if the $235,000 had n
been included in income, the fact that the company had not acguired ti'
ta the nursing homes and no deed, title search, or title insurance had bei
obtained.

The judge concluded that disclosure of the “true facts would ha

caused a reasonable man in Herzfeld's position not to buy the FGL secu
ties.”!

Empiricai Studies

A number of empirical studies have been conducted on materiality. Th

can be classified as those that focus on the preparer or auditor of t
financial statements, and those that concentrate on the user of the st
ments. An early investigation of the first type was done by Woolsey. |

19 Herzfeld v. Laventhol, Krekstein, Horwath & Horwath, Fed. Sec, Law Reports (New Yo
1974), p. 96,002.

'4Samuel Woolsey, “Development of Criteria to Guide the Accountant in Judging Matt

ality,” Journal of Accountancy, February 1954, “Judging Materiality in Determining Regui
ments for Full Disclosure,” Journal of Accountancy, December 1954.
MATERIALITV 591

employed a guestionnaire consisting Of ten situations in which materiality

decisions were to be made. The majority of the respondents in his study
were CPAs, controllers, and accounting professors. The particular case
involved an earthguake loss. Woolsey found that a substantial majority of
the respondents made their materiality decisions based on the ratio of the
amount of the loss to current year's income. He suggested that a zone of 5—
15 percent of current income before income taxes be used for materiality
judgments where any income item within the zone might be material or
immaterial, depending on circumstances. An amount below the lower limit
would be judged immaterial, one above the upper limit would be material.

In a later study concerning an error in the calculation of cost of goods

manufactured, Woolsey found that 65 percent of the 176 respondents
based their materiality decision on the ratio of the error to current income
before income taxes.'

Boatsman and Robertson, Neumann, and Frishkoff, in other studies,

came to the conclusion that the main consideration in materiality decisions
was the relationship between the item in guestion and current income.!S
Except for this, however, there was no uniformity of approach found in
practice.

Rose et al. concentrated on users in their study.” They wanted to deter-

mine how much of a change in earnings per share was considered material
to users. Their findings are limited, however, because students were
utilized in a laboratory situation. Basically, the researchers found that a
change of about 6.5 percent made a difference in the response of the
students.

Reckers, Kneer, and Jennings undertook a survey to determine the per-

spective of judges, lawyers, and accountants with respect to materiality
decisions.'8 The sample included 93 judges and lawyers and 73 auditors,
mostly from the Big Eight. They found that 75 percent of the participants
needed more than one financial dimension to make a decision concerning
materiality. Nearly 50 percent reguired three or more dimensions, whereas
only 20-25 percent could decide on the basis of only one. They also found
that the majority of the judges (72 percent) and lawyers (61 percent) pre-
ferred more explicit guantitative standards, whereas only a minority of the
auditors (18 percent) did.

15 Samuel Woolsey, “Materiality Survey," Journal of Accountancy, September 1973, pp. 91-92.
' James Boatsman and Jack Robertson, “Policy-Capturing on Selected Materiality Judg-
ments," Accounting Review, April 1974: Fred Neumann, “The Auditing Standard of Consis-
tency," Journal of Accounting Research Supplement, 1968: Paul Frishkoff, “An Empirica! Investi-
gation of the Concept of Materiality," Journal of Accounting Research Supplement, 1970.

17J. Rose, W. Beaver, S. Becker, and G. Sorter, “Toward an Empirical Measure of Materi-
ality,” Journal of Accounting Research Supplement 1970.

'8 Philip Reckers, Dan Kneer, and Marianne Jennings, “Concepts of Materiality and Disclo-
sure," The CPA Journal, December 1984.
522 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

General Auantitative Criteria

In Australia, specific guantitative criteria for determining the materiality of

information have been established. These are:'”

|. An amount egual to or greater than 10 percent of the appropriate

base amount is presumed to be material unless there is evidence to
the contrary.

2. An amount egual to or less than 5 percent of the appropriate base

amount is presumed to be immaterial unless there is evidence to the
contrary.

3. The materiality of an amount which lies between 595 and 1095 of the
appropriate base amount is a matter of judgment, depending on the
Ccircumstances.

The FASB expresses the opinion that “no general standards of materi-
ality could be formulated to take into account all the considerations that
enter into an experienced human judgment.”20 Individual judgments are
reguired to assess materiality, or to decide what the appropriate minimum
guantitative criteria are for given situations.

RELIABILITY

The FASB states that the reliability of a measure has to do with how
faithful the measure represepis what it purports to represent.?' In general
usage, reliability can be viewed in two ways. First, to say that a measure is
reliable is to say that it can Be depended on to do the job for which it is
used. Second, a measure is reliable if it is a correct guantitative description
of the actual condition, object, or event it represents. The first implies
effectiveness, but in accounting we prefer to cal this guality relevance. It is
the second meaning that the FASB prefers for the term reliability. As men-
tioned earlier, the FASB sees reliability as consisting of three components:
representational faithfulness, verifiability, and neutrality.
Representational faithfulness, the most critical element of reliability,
concerns the correspondence between a measure or description and the
economic object or event it purports to represent. The objects are assets
and liabilities, and the events are the changes in their value, namely, reve-
nues, expenses, gains, and losses. Numerous guestions about the reliability
Of accounting information have been raised for which answers are difficult

" National Council of the Instiute of Chartered Accountants, and General Council of the
Australian Society of Accountants, Statement of Acrounting Standard DS 7, August 1974.

?0FASB Concepts Statement No. 9, paragraph 131.

2 Ibid., paragraph 59.
OBJECTIVITY 523

to formulate. For example, suppose the balance sheet.of a certain company

includes accounts receivable of $50,000. To assert that this item is reliable is
to contend that the company truly has a collectible amount of $50,000.
How accurate must this figure be to say that it is reliable? Auditors may
confirm the receivables by the use of statistical procedures, but the
confirmation is for the existence of the receivables, not the collectibility of
the amount. Also, the cost of an asset may not always be ascertained unam-
biguously, especially if cash is not involved. The fair value or current cost
of assets may also entail difficulties in their determination.

The existence or reality of an item is one concerning reliability. As

discussed in Chapter 9, Thomas guestions the reality of allocations. Others
argue that future values, such as expected salvage value for the determina-
tion of depreciation expense, are not real, they do not exist presently. Suill
others guestion whether certain deferred credits, such as deferred income
taxes, represent a real liability. Is it possible to declare a figure to be reliable
if it does not represent something real? Is it meaningful to say, for ex-
ample, that the expected sales price or expected salvage value of an asset is
a reliable estimate? The FASB does notaddress itself to such guestions, but
it does point out that accounting information is the result of “approximate,
rather than exact, measures involving numerous estimates, classifica-
tions, summarizations, judgments, and allocations.”??

OBJECTIVITY

Although the FASB in Concepts Statement No. 2 does not speak of objec-
tivity, this term has been used freguently in practice and in accounting
literature. It obviously relates to reliability, and therefore we discuss it at
this juncture.

Objectivity as a Criterion in Accounting

The accounting profession has long acknowledged the necessity for objec-
tive data. Paton and Littleton remarked that one of the significant contribu-
tions made by professional auditing in its early years of development was
the emphasis placed upon objective evidence.” They further stated that

verifiable, objective evidence has become an important element in accounting

and a necessary adjunct to the proper execution of the accounting function of
supplying dependable information.?4

2? Ibid., paragraph 64.

?8William Paton and A.C. Littleton, An Introduction to Corporate Accounting Standards (AAA,
1940), p. 18.

24 Tbid.
524 Chapter 17/@UALITATIVE CHARACTERISTICS OF ACCOUNTING

Authoritative bodies have also recognized the importance of objectivity.

For example, the Committee on Accounting Procedure in Bulletin 43, with
reference to stock options, lamented that “there is no objective means for
measuring the value of an option which is not transferable.”?? The APB in
Opinion 29 stated that certain nonreciprocal transfers of nonmonetary "
assets should be accounted for at fair value “if the fair value is objectively
measurable.”” The FASB, in Statement 2 on research and development
costs, Supported its conclusion by arguing that measurability reguires that a
resource be recognized as an asset only if “at the time it is acguired its
future economic benefits can be identified and objectively measured.”?2”

Meaning of Objectivity

Often the term objective is contrasted with the word subjective. The differ-
entiation between ofyect and subject is emphasized. The idea is based on the
philosophy that objective truth is something that is external to the human
mind (the subject). But how truth can be discerned without using the mind
of man is difficult to see. Itis a myth that human perception is not involved
in the ascertainment of truth. To contrast objectivity with subjectivity can
be misleading, if by the latter is meant the utilization of human thought
processes. Rather, the contrast should be with a narrower view of subjectiv-
ity, namely, introspectivity. This refers to something that is purely personal
and hidden from public scrutiny.

Likewise, it is also misleading to contrast objectivity with professional

judgment, if by the latter we mean the forming of conclusions based on
training and experience. Without judgment there is little a person can do.
As with other human endeavors, the accounting process includes many
nonobjective elements that must be dealt with in the best way accountants
know how.

When perception and judgment are accepted as inevitable, objectivity is

interpreted by some as a certain state of mind of the observer or investiga-
tor. Paton and Littleton, for example, saw it as freedom from personal
bias.?8 Terms such as neutrality, impersonality, and impartiality denote the
same standpoint. The FASB considers “neutrality” to be a component of
reliability.

23 Committee on Accounting Procedure, “Compensation,” Chapter 13, paragraph 12, in ARB

No. 43, June 1953.

26 APB, “Accounting for Nonmonetary Transactions,” APB Opinion No. 29, May 1973, para-
graph 23.

#7 FASB, “Accounting for Research and Development Gosts." Statement af Financial Accounting
Standards No. 2, October 1974, paragraph 44.

28 Paton and Littleton, op. cit, pp. 19-20.

OBJECTIVITY 525

Some social scientists and philosophers have expressed doubt about

whether freedom from bias or neutrality is attainable. Gunnar Myrdal has
pointed out that the personal values of an investigator influence his conclu-
sions.?' Values are defined as the ideas of what ought to be or ought to have
been. Myrdal argues that people are influenced by traditions, their envi-
ronment, their background, their personality. In a similar vein, Karl Mann-
heim contended that not only do values affect the thinking of an observer,
but one can detect distinct modes of thought in different historical periods
and in different cultures.”? Michael Polanyi states that perception involves
a selecting process and that our “percepts” are shaped by our prior be-
liefs.?! In his argument Polanyi refers to Gestalt psychology, where psy-
chologists have found that the way people describe an ambiguous picture is
dependent on their personal beliefs and desires.

Granted that an observer's perceptions and judgments are influenced by

culture, tradition, education and other social forces, yet this does not pre-
clude the realization of objectivity. In fact, the meaningfulness of a crite-
rion of objectivity is based on the acceptance of the existence of these
influences. The idea is to control these influences within an acceptable
range. It is therefore not senseless to speak of neutrality, or freedom from
bias, or objective evidence.

Suggested Control Devices

Concern for objectivity is in recognition of the fact that judgment must be

exercised in the accounting process, but that in making judgments the
possibility of inaccuracies exists. Earlier, objectivity was described as free-
dom from bias, which has to do with the state of mind of the observer. But
we cannot be expected to read people's minds. From an operational point
of view, we see obyectivity as pertaining to the establishment of specific
control devices to help accountants minimize inaccuracies in the observa-
tion-measurement process. The control devices have to do with making
public or external what is essentially introspective: with eliminating per-
sonal biases as much as possibie: and with obtaining general agreement of
these control devices. To some extent, rules under the headings of disclo-
sure, consistency, comparability, and materiality, as well as generally ac-
cepted accounting principles, are practical control devices reflecting the
desire for objectivity. 0

In the accounting literature, the practical control devices offered under

2Gunnar Myrdal, Value in Social Theory (Harper, 1958): Objectivily in Social Research (Pan-
theon, 1969).
30 Karl Mannheim, Ideology and Utopia (Harcourt, Brace, 1968), first published in 1936.
3! Michael Polanyi, Science, Faith and Soczety (University of Chicago, 1964), p. 11.
526 Chapter 17/8UALITATIVE CHARACTERISTICS OF ACCOUNTING

the caption of objectivity have taken three forms:

|. To make specific and precise the concepts and protedures of ac-

counting and to obtain general agreement on them.??

2. To determine a consensus of the measure among a number of ex-

33
perts.

3. To improve the standards of competence and ethics of the profession. 4

To formulate procedures is to make public what is to be done. And to

express these procedures more precisely not only decreases the likelihood
of making errors of application, but also increases the possibility for others
to verify the results of the procedures. Verifiability is an important element
in the accounting process. It is mentioned by the FASB as a component of
reliability. But it is meaningful only if the procedures are considered gen-
erally acceptable. Verification can occur only if the procedures utilized are
accepted as valid. Thus, general acceptance is itself a control mechanism.
To obtain general acceptance of the “rules of the game” is desirable: other-
wise chaos would ensue. We need to agree on how to observe and measure.
If we were to measure the height of an individual, we need to agree on
whether the person should be standing or sitting, whether he should have
his shoes on or off, and so on. General acceptance of the rules of the game
is important, but it does not necessarily indicate that the rules are the best
Or most appropriate for the game. Determining the most appropriate rules
pertains to relevance. Deciding between LIFO and FIFO, or historical cost
and current cost, is a problem of relevance. To judge what are the best
rules, we need evidence. In the sciences, the evidence consists of objective,
empirical data as well as logical argumenis. Presently, in accounting prac-
tice, the presumption is that extint generally accepted accounting princi-
ples are the most suitable for achieving the objectives of accounting.

The consensus view of objectivity attempts to eliminate, or at least lessen,

the effect of personal bias and poor judgment. This viewpoint can be
interpreted in three different ways. The standard interpretation, as pre-
sented by Ijiri and Jaedicke, is that consensus represents the agreement
among the results produced when the same procedure is applied by vari-
ous measurers.? However, since the focus is on the measure, it is possible

?? Raymond Chambers, “Measurement and Objectivity in Accounting," Accounting Review,

April 1964: E. Burke, “Objectivity and Accounting," Accounting Review, October 1964: J. .
Wojdak, “Levels of Objectivity in the Accounting Process," Accounting Review, January 1970.
“8 Yuji Ijiri and R. Jaedicke, “Reliability and Objectivity of Accounting Measurements," Ac-
counting Review, July 1966, reprinted in Y. Ijiri, The Foundations of Accounting Measurements
(Prentice-Hall, 1967): E. McDonald, “Feasibility Criteria for Accounting Measures,” Accounl-
ing Review, October 1967, R. Ashton, “Objectivity of Accounting Measures,” Accounting Re-
view, July 1977.

“J. Wagner, “Defining Objectivity in Accounting," Accounting Review, July 1965.

“ Ijiri and Jaedicke, op. cit.
CONSERVATISM 527

to have a consensus even if a different procedure is used by each measurer,

as long as the results are in harmony. Another possibility for consensus is
the case of one measurer utilizing different procedures to derive the same
conclusion. Ashton argues that the interpretation of objectivity in an abso-
lute sense reguires independence of rules and measurers and that the
characteristics of the measurers, such as agreement or disagreeme€nt about
conservative valuation, may affect the magnitude of the measures pro-
duced.?8

The third type of mechanism seeks to improve objectivity in the account-

ing process by increasing the standards of competence and ethics in the
profession s0 that accountants will be less likely to make errors of judgment
or to willfully misrepresent their observations. The profession, of course, is
attempting to improve these standards, but they are no guarantee against
poor judgment-or personal bias.

Objectivity Applied in Practice

For many accountants, determining values not derived from actual transac-
tions in which the firm is a participant is disturbing. They argue that values
of this type do not have confirmation by an external party, and therefore
are conducive to manipulation and bias. However, it is possible to obtain
agreement from external parties other than by transactions. If procedures
for ascertaining values are made public and are generally accepted by the
profession, other competent, external parties can verify them. In this way,
the values can be considered objective.

Objectivity alone does not lead to useful information. However, there

are practical reasons why we may emphasize the evaluation of accounting
data for their objectivity. First, if by empirical evidence a procedure has
been found to furnish relevant information, then thereafter one need only
to examine the data for their objectivity. Second, if by logical argument a
certain procedure has been judged to provide relevant results, then the
results need only to be determined objective. Third, in many cases, to
discern whether a procedure truly provides relevant information is
difficult, therefore, relying on the good judgment of users to select data for
themselves, we can at least determine that the data are objective.

CONSERVATISM

Conservatism is not mentioned by the FASB as an element of useful infor-

mation, but it is too pervasive a convention to be ignored. The APB recog-
nized its influence and listed conservatism as a modifying convention of

36 Ashton, op. cit.

528 Chapter 17/@UALITATIVE CHARACTERISTICS OF ACCOUNTING

financial accounting in Statement No. 4.” It explained that assets and

liabilities are often valued in a context of significant uncertainties, and
accountants have therefore responded by taking a conservative stance. In
the face of uncertainty of values, accountants prefer to err on the side of
understatement of positive items (assets, revenues and gains) and over-
statement of negative items (liabilities, expenses and losses). This has led to
the practice of anticipating losses but never anticipating gains.

Historical Background

Chatfeld traces the convention of conservatism to the Middle Ages, when

the lord of the manor left the running of his estate to a steward.”8 The
steward soon realized that taking a conservative position was a means of
self-protection. It was safer not to anticipate increases in the value of assets,
because if they failed to materialize the lord might hold the steward re-
sponsible.

In late-nineteenth-century England, Chatfield points out that auditors

were often named as defendants in lawsuits brought by investors after the
bankruptcy of a company. Auditors found that they were never sued on
the grounds that the financial statements were conservative, only for over-
statement of net income and capital. In the United States, bankers were the
most influential users of accounting information, and they wanted a con-
servative approach. Certainly the experience of the 1920s and the ensuing
“crash” solidihed the desire for. conservatism.

.N
Criticisms of Conservatism

Through the years, the convention of conservatism has been criticized by

many accountants. A sumniary of the criticisms follows:??

1. Inconsistency. When an asset is uriderstated, it will cause an overstate-

ment of income when the asset is used or sold. Paton and Littleton
pointed out that the “amount by which income is understated in one
year through the application of “cost or market," as compared to the
use of cost, is in effect added to the showing of income in the follow-
ing period.” If conservatism is based on the preference to under-
state income, it is inconsistent because income of a future period will
be overstated.

2? APB Statement No. 4, paragraph 171.

38 Michael Chatfield, unpublished paper, Accounling Principles Considered as Conventions: Doc-

trine of Conservatism, California State University, Hayward.

38Cf. Chatfield.
“0 Paton and Littleton, op. cit., p. 128.
CONSERVATISM 5

rs
md

2. Capriciousness. The extent of conservatism in the financial state-

ments is a matter of policy by the firm. It may be great or small.
Anticipated losses, for example, may or may not be recorded, because
expectations can always be revised. Anticipated losses from lawsuiis,
for instance, can be nullihed by a more opumistic analysis if the firm
prefers the latter.

3. Goncealment. Although it is generally known that accounting

methods are conservative, it is difficult for investors to determine the
amount of the understatement of assets. Conservatism puts the aver-
age investor in a disadvantaged position, and gives advantageous op-
portunity to “Insiders.”

4. Contradiction of accounting principles. Sterling indicates that

whenever conservatism clashes with an accounting principle, it pre-
vails over the principle.'! The following are examples:

Conservative method Principle contradicted

Lower of cost or market Cost principle
Installment basis of revenue Sales revenue recognition

recognition (cash received)

Expensing of R & D Matching principle
Switching from cost to LOCOM Consistency principle
Understatement of asset values Disclosure principle

Conventional accounting is known for its historical cost, sales basis of

revenue recognition, and matching principles: yet these are violated
in preference for conservative policies.

5. Bias. Conservatism causes a systematic bias in the financial reports

rather than a realistic assessment. Because of this, as the FASB points
out, “conservatism tends to conflict with significant gualitative charac-
teristics, such as representational faithfulness, neutrality, and com-
parability (including consistency).””? There can be serious, legitimate
guestions raised about the usefulness of accounting data based on
conservative policies. The AAA argues, “The presence of bias which
may serve the needs of one set of users cannot be assumed to aid or
even leave unharmed the interests of others.”

6. State of mind. Conservatism is s0 entrenched in accounting that it has

become more an attitude, a state of mind, of accountants than simply
a mechanism used in response to uncertainty. Presumably, when

“1 Robert Sterling, “Conservatism: The Fundamental Principle of Valuation in Traditional

Accounting," Abacus, December 1967.

“2FASB Concepts Statement No. 2, paragraph 92.

“AAA, A Statement of Basic Accounting Theory, 1966, p. 11.
530 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

there is serious doubt about the valuation of an item conservatism

should come into play, but this does not appear to be the case. Con-
servatism has become an attitude of accountants toward all aspects of
accounting.

Defense of Conservatism

There is a natural tendency of managers and proprietors to be overly

optimistic about the business enterprise, and such Overoptimism is very
gutckly translated into overstatements of assets and income. Conservatism
is seen as a necessary antidote to overoptimism. Carl Devine argues that it is
difficult to dampen optimism and induce pessimism.“' One dollar of profit
creates more optimism than one dollar of loss creates pessimism. The con-
seguences of overoptimism are greater than the conseguences of over-
pessimism. To suffer ah actual loss due to an overoptimistic appraisal is
more severe than the loss of an opportunity for profit due to an over-
pessimistic evaluation. This is demonstrated by the fact that investors are
likely to sue an auditor for losses due to overinflated net asset values, but
not for understated net asset values.

Because of the unegualness of the conseguences of overoptimism versus

'Overpessimism, accounting rules for the valuation and recording of
liabilities, expenses, and Iosses do not have to be egual to those for assets,
revenues, and gains. One can anticipate a loss and not a gain: one can
recognize market values when they are less than cost and not do so when
they are above cost. 7

In reporting information, tha accountant is faced with the rule of mak-

ing one of two types of error: to reject information that subseguently turns
out to be true or to accept information that subseguently turns out to be
false. These errors are similar to those in statistical analysis where a type I
error is to reject a hypothesis that is true and a type II error is to accept a
hypothesis that is false. Making a type II error in accounting is sometimes
called the auditor's risk, because if an auditor judges something to be true
when in fact it is false, the conseguence is more serious than the reverse.
Devine argues that investors are more likely to be hurt by acceptance of
items by an auditor that are actually incorrect. Recognizing that these two
types of risk exist, conservatism can be said to be in conformity with statisti-
cal-probability analysis, and is therefore a rational way of dealing with
uncertainty.

Users, especially creditors, need to know that the financial position of

the firm is at least, minimally, that which is represented in the financial

“Carl Devine, “Rule of Conservatism Reexamined,” Journal of Accounting Research, Autumn

1963.
TESTING FOR RELIABILITY 531

statements. Creditors need to have a margin of safety to protect themselves

against adverse conseguences. Despite the criticisms, advocates maintain
that conservatism continues to be followed in practice because ycars of
experience have demonstrated to accountants Uhat il Is a prudent, useful
convention in an environment filled with uncertainty.

Position of FAS8 on Conservatism

The FASB acknowledges that there is a place “for a convention such as

conservatism—meaning prudence—in financial accounting and reporting
because business and economic activities are surrounded by uncertainty,”
but it waras that the convention needs to be applied with care.“ The FASB
asserts that conservatism should no longer connote deliberate, consistent
understatement of net assets and profits. Conservatism should no longer
reguire deferring recognition of income beyond the time that adeguate
evidence of its existence becomes available. It should no longer justify
recognizing losses before there is adeguate evidence that they have been
incurred. The best way to avoid injury to investors because of imprudent
procedures, the FASB argues, is to ensure thiat what is reported represents
what it purports to represent.

In his analysis of conservatism, Sterling concludes that it is the most

important valuation rule in accounting practice today." Although the
FASB does not favor the employment of conservative practices where the
effect is the conscious understatement of net assets and income, the fact is
that such practices are part of generaliy accepted accounting principles.
Even in its own authoritative pronouncements, conservative practices are
upheld, such as Statement 2 on expensing R & D.

TESTING FOR RELIABILITY

In the previous chapter, we stated that a direct empirical test of the general
theory of accounting is virtually impossible. This would necessitate a
study of the specific accounting systems that are based on the theory to see
if their outputs constitute useful information to users in their decision
making. But analyzing the evidence to ascertain whether accounting infor-
mation helped a user make the right decision is difficult, because other
variables affect the decision process. Rather than this direct approach to
testing, indirect procedures may be the only way to gather evidence on the
usefulness of accounting data. Those in the behavioral sciences have faced

“5FASB Concepts Statement No. 2, paragraph 92.

“5 Sterling, op. cit.
532 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

similar problems. An indirect approach taken by those in educational psy-

chology is to divide the problem into two parts: testing for reliability and
testing for validity.

The notion of reliability advanced by the FASB is comparable to that in

educational psychology. The FASB speaks of representational faithfulness,
neutrality and verifiability, which indicates that the focus is on errors or
bias. Psychologists speak of stability, consistency, and measurement error
when referring to reliability. Both psychologists and accountants show that:
they are mainly concerned with the dependability of the results, which
implies that the results are within an acceptable range of error. Psycholo-
gists have developed procedures to test for reliability by utilizing statistical
means. We are interested in the possibility of measuring the degree of
reliability.

Theory of Reliability

Whenever a measurement operation (instrument) is applied by the same

person to a particular object or event, the results are bound to be different.
For example, if a person were to measure the length of a given room four
times, he or she might obtain the following results: 40.23, 39.85, 40.19,
40.08 feet. Over a period of time as the applications are made, the varia-
tions will be due to either systematic or unsystematic (random) factors. The
reliability of measurement refers to the precision (lack of unsystematic
variation) with which some property is measured by specified operations
(instrument), it is the extent to“which our measurements do not contain
random fuctuations or unexplainable factors.”

The reasons for unsystematic error may be due to the imprecision of the
operation, lack of information, misinformation, miscalculation, and s0 on.
The reasons all refer to the measurer in terms of how he or she is affected
in performing the measurement or valuation operation. Almost every op-
erating part of the accounting system demiands that certain judgments be
made by the accountant. For example, if historical cost is used, then deci-
sions about useful lives of depreciable assets and their salvage values must
be made. How reliable are these judgments?

We can view every value derived from a given operation as the sum of a
“normal” component and an “unsystematic error” component. That is,

XEN te
where . |
derived value
normal value
- unsystematic error component

X
N
e

“Edwin Ghiselli, J- Campbell, and S. Zedeck, Measurement Theory for the Behavioral Sciences
(Freeman and Co., 1981), p. 190.
TESTING FOR RELIASILITY 585

It is likely that each time individual A applies method M to object &, he or

she will obtain a somewhat different value. Therefore, an actually derived
value is only an approximation of the variable we wish to measure. The
actually obtained value is a sample from the distribution of possible values
that would be obtained if A applied M to ka large number of times. To
represent the object's distribution of poteritial values by a single “most
representative” value, we select the distribution's arithmetical mean and
call it normal value. The normal value of a given object £, therefore, refers to
the mean of the setvof all possible values that would be obtained by a
particular individual A for a given decision problem if he or she were to
use a specific method M. From a practical point of view, the definition of
normal value relates to a procedure that is most difficult to implement, but
it does give us a basis for an operational definition of normal value.

A derived value is an approximation of the object's normal value, but

differs from it by an error component. This error is an increment (positive or

. negative) that is a function of the particular circumstances underlying each

application of the given procedure. This intrusion of error between normal
value and derived value gives rise to the concept of a measurement opera-
tion's reliability.

To simplify our thinking, we make the following assumptions concern-

ing the relationship between normal value and the error component. First,
we assume that errors are as likely to be positive as negative and that in a
very large distribution their mean is zero. Second, we assume that in a large
distribution, errors are uncorrelated with normal values. That is, more
positive errors or more negative errors are not associated with any particu-
lar normal value.

A formal definition of reliability is that it is the proportion of normal

variance in derived values. Reliability, r, can be expressed as follows:

— Nariance of N
Variance of X .
or .

— NVariance ot e
Variance of X

The preceding theory of reliability is an idealization of real circum-

stances. Conseguently, we cannot directly determine r, the reliability
coefficient, but must revert to indirect,means to estimate the coefficient.
The theory gives us a basis for formulating indirect methods.

Estimating Reliability

On a practical level, reliability relates to the stability and consistency of

judgments in the employment of a given set of Operations. We would like to
5384 Chapter 17/@UALITATIVE CHARACTERISTICS OF ACCOUNTING

know whether:

1. A given individual would express the same judgment (opinion) about

the same object or event at different points of time (assuming time is
not a crucial factor).

2. A given group of individuals would each express the same judgment

(opinion) about the same object or event at a given time.

This second interpretation is similar to “objectivity” as defined by Ijiri

and Jaedicke."" Ifa set of operations is explicit in all of its specifications,
then reliability would be high, because judgments made and applications
undertaken would be iess subject to ambiguities. When we say that an
accounting system or set of operations is reliable, we are saying that judg-
ments made are consistent. That is to say, if the judgments have been made
by a single individual, we believe that his responses are consistent with
those he or she would make if asked to respond to the set of operations at
different occasions. If the judgments have been made by a group of ex-
perts, we believe that their judgments are substantially in agreement and
are consistent with those they would offer if they were asked to respond to
the set of operations at another time.

To determine reliability guantitatively, we need two sets of answers from

the same individual, or one set of answers and a “standard” set for the
purpose of correlation to derive r.

Based on the procedures used in psychometrics, the following illustra-

tions are presented on how reliability might be determined for a set of
measurement operations. The simplest way to determine r is to ask the
individual to respond on two separate occasions. The correlation between
the two sets of answers for a number of people will be an estimate of r. This
procedure has its limitations. An individual is likely to remember what he
or she said previously, and offer the same response without going through
the necessary steps to get the answer. One solution to the problem is to
lengthen the time between the two responses so that memory will lapse. We
may also test for reliability by obtaining the opinions of other experts, and
correlate the average of these opinions with that of the accountant in-
volved. In this case, the average of the opinions of other experts becomes
the standard answer. This is similar to the procedure used by financial
analysts in comparing given ratios of a particular company with the indus-
try average.

TESTING FOR RELEVANCE

As mentioned earlier, the FASB believes that relevance of accounting in-

formation for decision making by users relates to the characteristics of

“8 Ijiri and Jaedicke, op. cit.

TESTING FOR RELEVANCE 53

Kn

predictive value, feedback value, and timeliness. Sterling believes that the
relevance of accounting measures pertains to whether the given attribute
being measured is specified by the decision model employed."? A decision
model, in effect, is a general statement, except that an objective is also
indicated. The type of problem faced specifies what type of decision model!
is needed. Accounting concepts and measures based on them can be tested
for relevance by determining if the concept is used in at least one decision
model.

Whichever way we view relevance, persuasive evidence must be for-

warded to suggest conclusions about the relevance of accounting measures
for given types of decisions. If the output of a given set of operations is
found to be relevant for certain decision-making problems, then we can say
that the set of operations is valid. That is, the measurement instrument is
valid because it does what it is-supposed to do, furnish relevant infor-
mation.

The FASB makes reference to studies and procedures in educational

psychology regarding the concept of validity.39 The board eguates validity
with representational faithfulness, one of the components of reliability. But
validity in'educational psychology goes beyond the FASB's notion of repre-
sentational faithfulness. Validity actually relates to relevance. A psycholo-
gist, Jum Nunnally, states, “strictly speaking, one validates not a measuring
instrument but rather some use to which the instrument is put.”!

Construct Validity

There are three ways of looking at validity. First is what is called construci
validity. A construct is an abstract variable that is put together (constructed)
by an investigator or those in a given field of study, such as intelligence,
anxiety, financial condition, profitability, liguidity, or risk. These are con-
sidered important attributes that are believed to exist but have no direct
real-worid correlates. A set of operations is developed to measure the
construct, and the guestion arises as to whether the set of operations truly
measures the construct. Is the set of operations, the instrument, valid? To
answer the guestion, we need to begin with the definition of the construct,
which usually implies how it relates to other constructs and specific, observ-
able variables.

The construct then is seen as the theory that implies certain theorems
about observable relations that are to be tested empirically. Essentially, this
is the same scientific, deductive process we described in the previous chap-
ter. In accounting, for example, income is a construct. We have a theory of

“9Robert Sterling, Toward a Science of Accounting (Scholars Book, 1979), p. 85.

50FASB Concepts Statement No. 2, paragraph 68.
B'Jum Nunnally, Introduction to Psychological Measurement (McGraw- Hill, 1970), p. 133.
536 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

income that implies how income should be measured and how it relates to
other constructs, such as financial condition, and to observable behavior,
such as dividend payment by the firm or investment behavior of stockhold-
ers. The validity of the measurement operation relates to the empirical
evidence in support of the measure in relation to certain observable behav-
iors implied by the construct. One of these behaviors pertains to the
usefulness of the income figures to users in their decision making. This has
to do with relevance. Construct validity directs us to discover the implica-
tions of the abstract variable regarding observable behavior.

Content Validity

The second way te view validity is called content validity. This relates to the
guestion, “Is the measurement instrument adeguate to do the job for which
it was formulated?” In the field of education, for example, we might want
to know if the final exam for a certain intermediate accounting course
adeguately measures the performance of the students. It is the content of
the exam that is in guestion. In accounting we might wonder if the content
of the set of operations to measure income is valid. For example, should
extraordinary items be included or excluded?

The primary way to answer the guestion of content validity is to have a

group of experts examine the measurement instrument and make a judg-
ment about its validity. Appeal to rationality, to logic, is the basis for deter-
mining validity. The problem is that different people think differently
about what is rational. This is # weak procedure for ascertaining validity,
but it is acceptable if seen simplyas one of three approaches rather than the
only one. Presently, in accounting practice, this appears to be the way
we determine the validity, that is, the relevance, of our measurement oper-
ations.

Predictive Validity

The third and most effective approach to the guestion of validity is called
predictive validity. This is an empirical procedure where attention is focused
on whether a measurement operation is valid in furnishing results that can
be used to predict a certain form of behavior. For example, a test may be
given to high school seniors where the score is employed to predict success-
ful performance in college. Predictive validity calls for an empirical investi-
gation where the scores on the test would be correlated with, say, grade
point average in college. Assuming that there is a high correlation, then for
that particular purpose the test would be valid: that is to say, the test scores
are relevant for the objective of predicting or estimating success in college.

Studies on the predictive value of accounting information are based on

CONCLUSIONS 527

rif

the notion of predictive validity. For example, a high correlation between

the results derived from certain financial ratios and bankruptcy leads to the
conclusion that accounting data utilized in certain financial ratios are valid
for predicting bankruptcy: that is, they are relevant for at least that pur-
pose. This tells us that the way to test accounting theory empirically may be
to employ the output of actual accounting systems based on the theory and
validate it for specific uses.

CONCLUSIONS

Theory is seen as an instrument to serve a certain purpose. One does not

ask of an instrument, “Is it true?” Rather, one asks, “Does it work?" Does it
do the job well for which it was formulated? Accounting theory serves as a
blueprint for the construction of actual accounting systems whose purpose
Is to provide useful information to users. If we can determine that the
output of the systems is useful, then we can have confidence not only in the
systems, but also in the theory. But a direct empirical test for ascertaining
the usefulness of accounting data is difficult to perform.

The FASB states that usefulness of accounting information means that it

is relevant and reliable. This breakdown suggests to us how we might
indirectly test accounting theory. The approach taken by educational psy-
chologists is based on a similar analysis. First, there is a test for reliability,
which essentially has to do with determining how much error is involved in
our measurements. The notion of objectivity is very close to that of reliabil-
ity. Objectivity comprises those practical control devices to minimize errors
and bias in accounting. The following suggestions have been advanced:

1. To make specific and precise the concepts and operations of account-

ing and obtain general agreement on them.

2. To determine a consensus among a number of experts of a particular

measure.
3. To improve the standards of compeience and eihics for the
profession.

The consensus view is similar to the approach in educational psychology

for reliability.

The FASB states that conservatism should no longer mean the deliber-
ate understatemeni of net assets and income, which creates a bias in re-
ported data, but that information should represent “what it purports to
represent.””? However, despite what the FASB says, conservatism is a con-
vention that is deeply entrenched in practice.

32 FASB Concepts Statement No. 2, paragraph 97.

538 Chapter 17/AUALITATIVE CHARACTERISTICS OF ACCOUNTING

Accounting information is relevant when it makes a difference in the

decision making of the user. The concept of materiality is directly pertinent
to the concept of relevance. The answers to the guestion of materiality are
one source of practical solutions to the problem of determining relevant
information. Empirical studies.indicate that the ratio of an income item to
current income is a popular guide for materiality judgments. But there
appears to be little uniformity of practice for other items. Many accoun-
tants believe that the FASB should furnish guantitative guidelines on mate-
riality, but presently the FASB does not favor this course of action.

An affinity can be seen between testing for the relevance of accounting

information and testing for validity in educational psychology. Predictive
validity is created when the measures from a given set of operations are
found to correlate with a certain use of those measures. Empirical studies
to ascertain the predictive value of certain types of accounting information
are of this nature. If the correlation is high, it can be said that the account-
ing information in guestion is relevant for that particular type of decision,
such as the employment of guarterly income to predict annual income.

The FASB tells us that a trade-off between reliability and relevance may
be necessary or beneficial.”? It is possible for an item to be highly reliable,
but not relevant. It is also possible for an item to be more relevant than
another item, although its reliability is not as high. However, it does not
seem possible that an item can be very unreliable and be relevant. Informa-
tion that is erroneous to a high degree cannot be relevant.

'

AUESTIONS

1. According to the FASB, what is relevance? What is reliability? How do

these characteristics relate to the notion of useful information?

2. Define materiality.

3. Mention three cases where guantitative materiality rules are given by

an authoritative accounting body. Are they necessary?

4. What was the significance of the BarChris and Herzfeld cases with re-
spect to materiality?

Assume that you are in favor of the establishment of guantitative mate-

riality guidelines by the FASB. What would your argument be?

33 Tbid., paragraph 42.

10.

11.
12.
13.
14.

15.

16

17.

18.

AVESTIONS 530

- Assume that you are opposed to the establishment of guantitative ima-

teriality guidelines by the FASB. What would your argument be:

. Company X determined that the current cost of its eguipment at the

end of the year is $60,000. The auditor wonders about the reliability of
the figure. What does he mean?

. How does obyjectivity contrast with subjectivity?

. Is it meaningful to speak of neutrality or freedom from bias? Explain.

Explain the relationship between objectivity and control devices. Whai

are the three forms the latter has taken in the accounting literature?

Mention three criticisms of conservatism.

Mention two reasons conservatism is a desirable convention.
How would you interpret the FASB' position on conservatism?

Briefly explain the theory of reliability in educational psychology. Pre-

sent one way in which reliability might be estimated in practical
situations.

Discuss the notion of construct validity and the implication on how

income might be empirically tested.

Discuss the notion of content validity and the implication on how in-
come might be tested for this.

Discuss the concept of predictive validity and the implication on how

an overall theory of accounting might be empirically tested.

In December, Year 10, Raine Company's factory building was de-

stroyed by a fire. The original cost of the building, purchased 10 years
earlier, was $2,000,000. The book value just prior to the fire was
$1,000,000. This was 8 percent of total assets. It has been learned that
the insurance company will pay $800,000.

Without considering the fire ioss, the current year's income state-
ment shows the following:
Sales revenue £10,000,000
Cost of goods sold 5,000,000
Gross profit 5,000,000
"Operating expenses 2,000,000
Income before income taxes £3,000,000
Income tax expense (409) 1,200,000

Net income £1,800,000

540 Chapter 17/@UALITATIVE CHARACTERISTICS OF ACCOUNTING

19.

20.

According to APB Opinion 30, an item should be reported as extraor-

dinary if material. Decide whether the loss is material. What are your
reasons?

Suppose the fire mentioned in Ouestion 18 has caused a curtailment of

production. Because of the large amount of fixed expenses, as of De-
cember 31, Year 10, the company projects a loss of $300,000 for Year
11. On the basis of conservatism, should this expected loss be recorded
in Year 10?

Raine Company discovered that the calculation of cost of goods sold in

Year 9 was overstated by $50,000. This was due to a misstatement of
Purchases. The other amounts on the Year 9 income statement are
basically the same as those for Year 10 (see Ouestion 18). Is the error
sufficiently material to warrant a correcting entry in Year 10?

Additional Readings

Devine, Carl. “Rule of Conservatism Reexamined." Journal of Accounting Research,

Autumn 1963.

FASB, “Oualitative Characteristics of Accounting Information.” Statement of Finan-

cial Accounting Concepts No. 2, May 1980.

FASB Discussion Memorandum. An Analysis of Issues Related to Criteria for Determin-

ing Matertality. March 1975.

Ijiri, Yuji, and Jaedicke, Robert. “Reliability and Objectivity of Accounting Mea-

surements.” Accounting Review, July 1966.

Sterling, Robert. “Conservatism: The Fundamental Principle of Valuation in Tradi-

tional Accounting.” Abacus, December 1967.