• materiality
• cost/benefit
• prudence
• industry peculiarities

The materiality constraint is often misunderstood. It does not apply while recording cash transactions. Even small amounts must be recorded. As a general rule, every cash transaction has to be recorded in the general journal.

If you want to alienate the Accounting Department, ask them to track down a $3.13 difference in the balance sheet. The trick, of course, is to discriminate between the trivial and the significant. What is the relative importance of the question? A $1,000 difference may not be worth the cost to correct to a company grossing $100M. To a company grossing $100K, it’s worth finding out the problem.

Materiality does not hold when errors of principle are found that need correction. Let’s say you learn that a capital item has been erroneously expensed or a different method of depreciation has been applied to a particular asset. The error should be corrected immediately. The concept of materiality cannot be a defense for not correcting errors.

Materiality just means that any of the aforementioned principles can be disregarded if there’s no discernible effect on the people who will use the financial information. Note that I’m not suggesting that fraud or carelessness in handling money is acceptable.

The cost/benefit constraint kicks in when the company tries to correct the $1,000 error mentioned above. What did it cost Captain Queeg to find out what happened to the strawberry preserves? How hard should the Defense Department look for a missing $100M? You decide whether it’s worth it.

Accountants and managers make many estimates. How much to reserve for warranty repairs? How much to set aside for uncollectible accounts? How long will a machine be in pro- ductive service? In reporting financial data, they should follow the prudence constraint. This means that when two outcomes are equally probable, the less optimistic should be reported. Better to understate than to overstate. So, when the new credit manager reports that the historic rate of 10% uncollectible accounts can be cut to 5% under enlightened leadership, stick with a 10% reserve allowance for doubtful accounts.

Because of fluctuations in several areas above, many industries have generally accepted accounting methods that are in clear contradiction with GAAP. When the use is of information benefit and a clear precedent, its use is acceptable in that industry. An example would be how depletion allowances are treated in the extraction industries.

An additional GAAP requirement is that companies use accrual basis accounting. To apply the various principles, cost, time period, matching, revenue recognition, and others, GAAP mandates the use of accrual basis accounting. Accrual is designed to capture the financial aspects of each economic event as it occurs. Concerns of cash flow, or when the cash actually changes hands, are not relevant to the actual event. Those transactions are recorded separately in the accounts receivable and payable transactions.

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