The Qualitative Characteristics of Relevance and Reliability - Essay Example

? Relevance and Reliability Due List of Contents Introduction………………………………………………………3 Theory……………………………………………………………..4 Practice……………………………………………………………8 The Application of Theory to Practice…………………………….11 Recommendations………………………………………………14 References………………………………………………………..17 Introduction Financial reporting is a legal requirement of a company. It shows the financial state of a company and helps in giving a clear picture of its financial affairs. There are many external users of financial statements of a company but the company itself can also use financial statements to judge and compare its own performance against the performance of other like companies. IASB has set standards for financial reporting which ensure that the reporting is done according to the set principles by all the companies. This helps the users of financial statements in making crucial economic decisions as there is no ambiguity due to different accounting styles. The standards ensure that a company provides all the relevant information that influences the financial needs of the users. There are specific areas that are not allowed to be left untouched. There is a possibility that some users require non-financial information about a company which is not available in its financial statements. There are a variety of users and their requirements are also different. Financial statements may be used by the employees of a company to know about their chances of obtaining a bonus. A cash flow statement of the year describes the liquidity of the company. Comparisons of statements of affairs of a year with those of preceding years help in evaluating the performance of the company. Relevance and reliability are important tools of achieving the goals of financial reporting. The information provided in the financial statements must be relevant for a given user or it would not be useful for him. It must also be reliable because users make crucial economic decisions on the basis of this information. Theory The IASB Framework has attributed four qualitative characteristics to the information that is to be provided in the financial statements. These are understandability, relevance, reliability and comparability (Para 24). Understandability and comparability can be discussed in the context of relevance and reliability as they cannot be separated from each other. According to Para 25, the information that is provided in the financial statements must be readily understandable by the users who have reasonable knowledge of business, accounting and economic activities and a willingness to study the financial statements. If the information is not understandable, it might not be reliable for the users because they would be reluctant to take decisions on the basis of such information. However, some information of complex nature has to be included in the financial statements to ensure that relevant information is available. Such information cannot be discarded merely due to the fact that it is difficult to understand. Para 26 of the Framework explains that information is relevant when it influences the economic decisions of users by helping them in evaluating past, present or future events (predictive role) or by confirming, or correcting, their past evaluations (confirmatory role). The predictive and confirmatory roles of information are interrelated. For instance, a user may take a decision on the basis of information regarding the current level and structure of asset holdings of a company. Here, this information would have predictive role. But the similar information might also prove to be the confirmation of previous predictions made by the similar or different users (Para 27). The predictive ability of information does not mean that it gives clear forecasts; it gives relevant and reliable information so that the users can make predictions themselves. For instance, when the contingent or infrequent items of income and expenses are reported separately, the users can easily predict the future by studying the stable items of income and expenses (Para 28). For information to be relevant, it needs to be material. An immaterial piece of information is not regarded as relevant because it does not influence the decisions of the users. When omission or misstatement of information influences the decisions of the users, the information is material and relevant. Statistically, if the amount involved in the information is more than 5% of the total profits, the information is regarded as material. The nature of information is also involved in the determination of its materiality. For instance, the reporting of a new section may affect the assessment of risk and opportunities facing the entity when its actual results are not very material. According to Para 30, Materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful. The information provided must also be reliable. When information is reliable, it is free from material errors and misstatements. The information must be free from bias and must present the true and faithful picture of the financial affairs of a company (Para 31). A user must be able to rely on the information provided. Misleading information is unreliable information and is not useful no matter how relevant it is. For instance, when there is a claim for damages under a legal action by a company, it would be inappropriate for it to recognize the whole amount of damages. However, it might disclose that a certain amount might be recovered in the lawsuit and what the circumstances of the lawsuit are (Para 32). Faithful representation is one of the most important perquisites of reliability of information. The information regarding all the transactions and events must faithfully represent what it purports to represent or what could reasonably be expected from it to represent. For instance, the balance sheet of an entity must faithfully represent all the transactions and other events that result in assets, liabilities and equity at the reporting date which meet the recognition criteria. Items which do not meet the recognition criteria at the reporting date must be left out of the balance sheet (Para 33). There is, however, an inherent difficulty due to which there is a risk that the financial statements might not be faithfully represented. This difficulty is not necessarily due to partiality. It might be due to the inherent limitations of the methods applied in identification of transactions and other events to be measured. There might be difficulties in devising and applying measurement techniques that can convey messages that correspond with those transactions and events. There are cases where the measurement of the financial effects of items is so uncertain that entities generally refrain from recognizing them in financial statements. A recurring example of such cases is the measurement of internally generated goodwill as it is difficult to measure this goodwill reliably. To provide with relevant information, entities recognize such items but also disclose the risk of error that surrounds their recognition and measurement (Para 34). In order to represent faithfully the transactions and other events that information purports to represent, the transactions and other events must be presented in accordance with their substance and economic reality and not just on their legal form. This is because the substance of the transactions is not necessarily consistent with that which is apparent from their legal or contrived form. For instance, an entity may dispose of an asset to another party in such a way that the documentation purports to show that the ownership has been transferred to the other party. However, in reality, the entity may still be enjoying the economic benefits embodied in the asset courtesy of an agreement. In this case, the reporting of sale would not be a faithful representation of the transaction hence making the information unreliable (Para 35). The information provided also needs to be completely free of bias and partiality; it must be neutral. If an entity presents an information in a manner that fulfills their own desired outcome, the information would be regarded as devoid of neutrality (Para 36). There are inherent risks of misrepresentation when financial statements are prepared. The preparers of the financial statements need to be aware of those risks. There a lot of uncertainties that surround various transactions and other events such as the collectability of doubtful receivables, the probable useful life of plant and equipment the number of warranty claims that may occur. In such cases, prudence is required in addition to the disclosure of the nature and extent of transactions and other events during recognition. Prudence is the inclusion of degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or incomes are not overstated and liabilities or expenses are not understated. The preparers must, however, be careful that they must not create excessive provisions and hidden reserves. Prudence does not mean that the assets may be understated or the liabilities may be overstated because in such case, the financial statements would lose their neutrality and hence, reliability (Para 37). The information must also be complete and no information having materiality and a financial impact should be omitted. Omission is tantamount to false or misleading information which is neither relevant nor reliable (Para 38). The users must be able to compare the financial statements of an entity through time to evaluate the performance of an entity and identify the trends in its financial position. They must also be able to compare the financial statements of an entity with those of other entities. Therefore, the process and method of the preparation of financial statements must be consistent throughout an entity and in a consistent way for different entities (Para 39). Practice The inherent limitations of faithfully representing financial statements can cause many problems. In practice, it turns out that it is very difficult to accomplish both relevance and reliability. There is a trade-off between relevance and reliability. Timeliness of information is an issue that was recognized at very initial stages by IASB. Information is relevant for the users when it is provided on a timely basis. Late information is of no consequence to the users. However, when information is provided on a timely basis, it might be provided at the time before all aspects of a transaction or other event are known. Thus, the information would be relevant but not reliable. On the contrary, if the information is withheld to be presented at the time when it becomes reliable, it might no longer be relevant. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the economic decision-making needs of users (Para 43). The cost-benefit analysis also puts a constraint on provision of relevant and reliable information in some cases. The preparers of financial statements must be sure that the benefit derived from information must exceed the cost of providing it. Good judgment is required to ensure this. A lot of aspects are to be considered like who will bear the cost of providing the information and who will benefit from the information. Therefore, it is difficult to apply a cost-benefit test in any particular case (Para 44). A balance or, sometimes, a trade-off is required between the qualitative characteristics to meet the objective of financial statements. This becomes a matter of choice and one characteristic has to be forgone to avail the benefit of another. What needs to be forgone to achieve an appropriate balance depends on the professional judgment of the preparers of financial statements (Para 45). The existence of a trade-off between relevance and reliability requires investigation because it is at the foundation level of the accounting discipline, and, despite this, there is a lack of investigation in the area (Stanga, 1980). The choice of valuing the assets on the basis of fair value or historical cost has been the topic of many debates in recent times. Fair value tends to be a proponent of relevance as it gives the most recent value of an asset. The users are generally interested in fair value of assets as fair value is more relevant to them than historical cost. Historical cost method of valuation favors the other side i.e. reliability. Historical costs are more reliable measurements of assets and give more authentic measures of how the benefits from an asset are flowing to an entity. However, this valuation is not based not the market values and is not very relevant to the users. In recent times, fair value system has been preferred over the historical cost method. This means that relevance has been preferred over reliability. Fair value accounting method gives fair value estimates and discloses a range of possible outcomes which may help a sophisticated investor but at the same may plague the unsophisticated investor with ambiguity and information overload (Abdul Aziz, 2010). It is possible for fair values to fluctuate dramatically in a very short period. Assets and liabilities can easily be overestimated or underestimated hence jeopardizing reliability. Critics have even argued that fair value accounting method aggravated the recent crisis by requiring significant write-down of assets and hence resulting in sharp decreases in regulatory capital of banks and other financial institutions (Avinash et al, 2010). However, it is worth noting that there are many arguments against the fair value accounting method but they don’t automatically become arguments in favor of historical cost accounting method (Power, 2010). Paragraph 15 of Concept Statements 2 explains that the prevalence of relevance over reliability must not be made a principle. Such decisions should be taken on case to case basis. Concept Statements 2 also explain that different users have different points of view regarding the preference of qualitative characteristic over the other. The views of the users might even contradict the views of the preparers. The auditors might put more emphasis on reliability to fulfill the legal requirements but the prospective investors might be looking for more relevant information because that would be the information that would direct their decisions to invest. It is a person’s perception that gives information a level of relevance which is specific to both need and to the current decision under consideration (Stamp, 1982). It has long been acknowledged that different user groups have different requirements and concerns from information that is disclosed in financial statements (Rayburn et al, 1991). The trade-off between relevance and reliability does not necessarily exist in all transactions or other events. Both of the characteristics can be present in varying degrees. The auditors may also face a dilemma of whether to favor relevance or reliability in such cases. According to Altaf N. Ali, the term “historical cost” is a misnomer as it is actually “historical fair value” whereas what we term as a fair value is virtual, not real as that would only be so in an actual transaction. This means that there is some extent to which relevance and reliability are interrelated and cannot be separated. The Application of Theory to Practice The qualitative characteristics of financial statements help them in ensuring that the objectives are achieved. The objectives of financial statements are to provide information about the performance, financial position and the changes in the financial position of an entity. The users of financial statements use this information to make crucial economic decisions. Financial statements also show the results of a management. The management is accountable for the resources that are entrusted to it. Financial statements show how the management has performed and has used those resources. The information provided must have the qualitative characteristic of relevance. The users can make use of information only when it is relevant to them. The preparers of financial statements must be aware of this and should not report irrelevant information. It is not easy to determine which information is relevant and which is not. It becomes a question of judgment and individual preferences whether a piece of information is to be included. A piece of information might be relevant to a class of users and might be irrelevant for others. In such cases, the auditors need to look at whether a majority of users would benefit from the information. Materiality is the guiding force for the determination of relevance of information. A piece of information might not have financial implications for a certain period but it can still be material because of its nature. If an entity is facing a lawsuit and a third party has claimed damages, the entity must disclose the existence of the lawsuit and the amount of damages that might be payable as a result. This information would not have any financial implications for the period in which it is reported but would have such impact in the next period. Therefore, the information would be material. The cost of providing information also creates some problems at times. It happens when the method of obtaining information is costly, for instance, when specialists are required to be hired to obtain certain results. The preparers consider whether the entity would be able to benefit from this information. Most of the times, an entity itself is able to benefit from such information but when it is not, it might opt not to provide such information. Therefore, this is a constraint on relevant and reliable information. Apart from the inherent limitations, there are also the risks of material misstatements. These are misleading pieces of information that prove to be very unfavorable. The Enron scandal was a fruit of deliberate misrepresentation. It has been discussed above that the fair value method is more relevant than reliable. Many financial companies had adopted this system for the valuation of their assets. Enron was the first non-financial company to adopt this system. It had different kinds of assets than the financial companies and had difficulty in showing the incomes at their present values. This created huge differences in the financial statements. Misleading and unreliable information was provided to the stock-holders and investors to match assets with liabilities and profits and cash. On the basis of this information, the users made wrong decisions. Enron displayed very less prudence and used to record the future incomes in earlier periods. Such incomes could not have been shown again in the later periods and there were discrepancies again. In order to pacify the investors and induce them to invest more, Enron started to add more artificial income from different projects. Their financial statements were window-dressed to a great degree. They had entered into a 20-year agreement with Blockbuster Video. This agreement was made to offer entertainment related services. Merely on the basis of market research, Enron estimated a profit of $110 million from the deal disregarding the risk of low demand for the service offered. The network failed, deal ended in a loss and Blockbuster Video pulled out but Enron continued to realize the profits. Enron could not continue its false and misleading reporting and had to suffer heavy losses. It lost a lot of customers and no one was willing to invest. At last, it was liquidated and shut down. The Enron scandal was a big shock and a lesson of what can happen when relevance is given too much importance while disregarding the prevailing circumstances. It was the absence of reliable information that caught up with Enron and its fraud was unveiled. Reliable information demands faithful representation which was absent from the financial statements of Enron. It was reporting income which was unearned. Uncertainty surrounded all of such transactions and the financial statements lacked faithful representation. The substance of the transactions and other events reported in the financial statements was very different from their legal form. Enron window-dressed the financial statements to lure investors which means they reported unfaithfully and partially. The biased information was against the principle of neutrality. Also, realizing unearned incomes in earlier periods defines the utmost absence of prudence. It is obvious that Enron did not give complete information to the users of its financial statements. Overall, Enron violated all the rules of provision of reliable information. The current and prospective users can learn from the Enron debacle that reliability must not be completely forgone. Some critics have blamed the fair value system for the demise of Enron but the fact is that it could not have happened without fraudulent intent. Recommendations The preparers or auditors must keep the overall objectives of the preparation of financial statements. The information provided must be such that it fulfills the common needs of most of the users. The human element is involved in the overall process of accounting and there is always a possibility that there would be imperfections in the rules. The problem of trade-off between relevance and reliability is a bitter reality and effective decisions can be taken by the efficient use of professional judgment. If the markets are well regulated, there is no harm in using the fair value system because it would be relevant and reliable too. If the markets fluctuate more than normal, it would be advisable to switch to historical cost method. It is not mandatory that when a trade-off is come across, relevance must prevail over reliability. That characteristic must prevail which is more likely to fulfill the objective of financial statements. It depends on the circumstances of a given transaction or other event that which characteristic should prevail. It is up to the good sense and judgment of the auditors to adjust to the requirements of time. The preparers and auditors need to be aware of the inherent limitations that are connected with achieving relevance and reliability. The constraint of timeliness causes some users to be left unsatisfied. The preparer, again, must use his skill and judgment to evaluate the consequences if the information is provided. The element of foresight and past experience can be used to determine whether information is worth providing. The application of cost-benefit tests should be applied where there are not many externalities involved. Externalities may refer to the non-financial influences and events that are connected with a particular piece of information. The preparers need to be aware of the externalities and take their decisions on case by case basis. The preparers must disclose all the material information in the financial statements. Prudence must be exercised where a loss is expected but too much prudence might result in too many provisions. Too many provisions might lead to overload of information which would tamper with the understandability of the financial statements. The auditors are required to be aware of the fact that the information obtained from the management might be biased. The auditor must test each and every piece of information objectively. He must not completely rely on the data provided by the management. IASB has set the standards for accounting and it has also presented with allowable alternate treatments. It is to make accounting methods flexible and responsive to changes. The qualitative characteristics of relevance and reliability are the very basics that are required to be followed to achieve the objectives of financial statements. The objectives would be automatically achieved if these requirements are fulfilled. It is almost impossible to strike a perfect balance among the qualitative characteristics of financial statements. It is a duty of the preparers to use their skill and judgment at the optimum level so that understandable, relevant, reliable and comparable financial statements are generated. References International Accounting Standards Board 2006. International Financial Reporting Standards. IASCF Publications Department, United Kingdom. Pp. 38-40. Aziz, Abdul. “Fair Value Accounting – Another Playground for Speculators?” The Pakistan Accountant 43.2 (2010): 6-8. Institute of Chartered Accountants of Pakistan. Web. 27 Apr. 2012. Noor Ali, Altaf. “Fair Value Accounting: What would you like it to be?” The Pakistan Accountant 43.2 (2010): 11-13. Institute of Chartered Accountants of Pakistan. Web. 27 Apr. 2012. Arya, Avinash, and Alan Reinstein. "Recent Developments in Fair Value Accounting." CPA Journal 80.8 (2010): 20-29. Business Source Complete. EBSCO. Web. 27 Apr. 2012. Financial Accounting Standards Board 2005. ‘Paragraph 15’ Concept Statements 2. N.a. Stanga, K. G. 1980. ‘The relationship between relevance and reliability: Some empirical results’ Accounting and Business Journal, vol. 11, pp. 29-39. Rayburn, W. B., Tosh, D. S., & Williams, R. E. 1991. ‘FASB concept statement 2: A framework for more useful appraisal reporting’ The Appraisal Journal, vol. 59, no. 3, pp. 319-328. Power, Michael. "Fair value accounting, financial economics and the transformation of reliability." Accounting & Business Research 40.3 (2010): 197-210. Business Source Complete. EBSCO. Web. 27 Apr. 2012. Stamp, E. (1982). “First steps towards a British conceptual framework.” Accountancy, 93, 123-130. Read More