Qualitative Characteristics of Financial Information - Essay Example

?Qualitative Characteristics of Financial Information Table of Contents Table of Contents 2 Introduction 3 Qualitative Characteristics of Financial Information 3 Materiality 5 Prudence & Neutrality 7 Relevance & Reliability 7 Conclusion 9 References 11 Appendices 13 Introduction This essay aims to present an analysis of the qualitative characteristics of the financial information and the major constraints presented by these characteristics. Financial reporting conceptual framework is a coherent system of concepts which underlie the financial information reporting. The objective or purpose of financial reporting is to present the information pertaining to the reporting organization, which is useful to investors and other capital providers in making decisions. The information is not just useful for the capital providers but also to the other user groups such as government, regulatory bodies etc. The next level of conceptual framework is the fundamental concepts i.e. qualitative characteristics of financial information and elements of financial statements. The third level is the implementation level, which contains recognition, disclosure and measurement concepts through principles, assumptions and constraints (Appendix 1). The qualitative characteristics of financial information are an important part of the total conceptual framework because they act as a bridge between the first level and third level of the framework. However, the definition of quality threshold of materiality and the conflicts between prudence and neutrality, and relevance and reliability has always been debated. In addition to the discussion of these constraints, this essay presents the Conceptual Framework for Financial Reporting 2010 provided by IASB as to how the new framework has placed these characteristics. Qualitative Characteristics of Financial Information The characteristics, which make the accounting information useful in decision-making by the users, are known as the qualitative characteristics (Porter and Norton, 2009, p.57). Prior to the international accounting standards convergence, both the standard setting bodies in UK and IASB differentiated between the qualitative characteristics related to the content of the information and those that are related to the presentation. The Conceptual Framework for Financial Reporting 2010 or commonly referred to as Framework 2010 states the objective of financial reporting that is to provide the financial information related to the reporting entity that can be helpful to investors and creditors in making appropriate decisions (McConnell, 2011). Therefore, in order for the financial information to be useful, it must possess some characteristics such as materiality, prudence, neutrality, relevance and reliability. An information is considered material if its misstatement, modification or omission can influence the economic decisions of the users, taken on the basis of that information. Materiality depends on the magnitude of the error in circumstances when the misstatement or omission has taken place. The financial statements are prepared in an uncertain environment due to many events such as useful life of fixed assets, collectability of doubtful receivables, and warranty claims. These uncertainties are recognized by exercising prudence while preparing the financial statements. Prudence means making careful judgement in making estimates in the uncertain conditions, so that the income or assets are not overstated and expenses or liabilities are not understated (IASC Foundation and IASB, 2008, p.25). Neutrality means that the financial information should be free from any bias and does not influence decision making in order to achieve predetermined outcome. Financial information is useful if it has the quality of influencing decisions by helping the users in evaluation of past, future and present events related to the reporting entity. The past information regarding the financial position and performance is frequently used for predicting the future performance and position. Information is reliable if it is free from significant errors and biases. The difference between FASB and IASB’s qualitative characteristics and financial accounting framework are given in appendix 2. However, there are a number of issues related to these qualitative characteristics. The materiality threshold is not easy to define and can be misunderstood. The conflict between prudence and neutrality stems from the fact that prudence demands exercising judgement under uncertain conditions so that the assets and gains are not overstated, and liabilities and losses are not understated, which can result in biased estimates whereas neutrality requires freedom from bias. Another conflict is considered between relevance and reliability because sometimes the most relevant information may not be more reliable and vice-versa. Materiality The concept of materiality should make the financial information more relevant to the users as materiality is closely related to relevance. However, the distinction between what information is material and what is not, is a matter of judgement and also depends upon the size of the reporting organization (Lunt, 2009, p.333). The materiality of an item in the financial statements depends partly on its value, partly on its effects on the financial results and partly on nature of that item. Those financial items that have relatively small number of monetary value, such as 3%-5% of the net profit or less, are not considered material unless their effect turns profits into losses or vice-versa. An example of this is the purchase of a coffee machine for office which is a capital expenditure because it will be used for many years and therefore, should be capitalized. However, the value of this item is very small and so it can be treated as revenue expenditure and included in the income statement in the financial period in which it was bought. Treatment of stationery, as an inventory at the end of the financial year, would require that it should be carried forward to the next financial year. However, doing so is considered a very cumbersome and tiring process whose effect on the profits is going to be minimal. Therefore, many firms do not adjust such inventories unless the value of the inventories is material. The concept of materiality can also be applied on the basis of aggregation and offsetting. Those items, which are material, are generally separately disclosed in the financial statements whereas small and immaterial items are grouped together. The convention of offsetting requires that the revenues and expenses, and assets and liabilities should not be offset. If the numbers are insignificant then they may be offset such as discount allowed and discount received. Framework 2010 describes the materiality of information as part of one of the fundamental qualitative characteristics i.e. Relevance. It is entity-specific, based on the entity’s magnitude and nature to which the financial information relates in the context of financial reporting (Deloitte Global Services Limited, 2012). Therefore, it is usually a set of factors that determine the materiality of the information. These are: 1. The item’s size in the context of financial statements and other information which can affect the user’s evaluation of financial statements. 2. The item’s nature with respect to the transactions and events leading to the item, legality, normality, sensitivity and potential consequences of the transaction or event, identity of the parties to the transactions, and the affected headings and disclosures. 3. In case of two or more items, the materiality of the aggregate items and individual items should be considered (Accounting Standards Board, 1999, p.45-46). Prudence & Neutrality It is debated that prudence and neutrality are two conflicting characteristics of the financial information where prudence incorporates bias in the seeking to ensure that under the uncertain conditions, assets and gains are not overstated and liabilities and losses are not understated but neutrality involves freedom from the systematic bias. However, the conflict arises only when there are uncertain situations. Generally, when uncertainty arises, the conflicting and competing demands of prudence and neutrality are reconciled through a balance between the two. For the companies report under UK GAAP, both the company law and FRS 18 require that the board makes prudent judgement while considering the accounts in uncertain situations. FRS 18 provides the requirements for the selection, disclosure and application of accounting policies (ICAEW, 2012). Both the IFRS and UK GAAP are focussed on the presentation of financial statements based on neutrality. For example, excessive provisions or hidden reserves are not allowed, which were used by the corporations to boost the profits. Prior to FRS 18, the concept of prudence was used to be given greater emphasis under UK GAAP. However, under FRS 18 the increasing emphasis on neutrality has stemmed from the growing concern over smoothing of profits. This has also driven changes under IFRS framework. In the Conceptual Framework Phase A, the concept of prudence as a qualitative characteristic was dropped due to its incompatibility with neutrality (Deloitte Global Services Limited-a, 2007). Relevance & Reliability Relevance and reliability are considered the primary qualities that make the accounting information valuable for decision making. When the standard-setters around the world are ready to replace historical cost system with the fair value system, the decision to assign weights to these two concepts is yet to be decided, because historical cost systems are considered more reliable whereas the fair value system is more relevant. So it has been debated for long that there is a trade-off relationship between relevance and reliability. Relevance is a characteristic, which helps the users to form future predictions based on the past, future and present events and from this either confirm or modify past predictions. Timeliness information is of paramount importance because if the information is not available when it can influence the decision making, it loses its value for future predictions. However, timeliness is not the only characteristic that makes the information relevant; however, it makes the information lose its value which once was relevant. On the other hand, the information needs to be reliable as well. Timely information is considered least reliable. So there has to be a trade-off between timeliness and reliability. The second primary quality reliability comprises three subsidiary qualities, representational faithfulness, neutrality and verifiability (Ernst & Young, 2008, pp.100-101). Representational faithfulness means that the true financial information must be reported. Neutrality concisely means bias-free information and verifiability means the information is coupled with an assurance for the user regarding the truthfulness of the information. FASB has put greater emphasis on fair value measurement of and entity in the financial statements because this makes the information more relevant for the users than the historical cost information. The fair value better represents the current financial position of reporting entity and therefore, assists in better assessment of past performance and future prospects. Therefore, according to FASB, reliability cannot outweigh relevance (Johnson, 2005, p.4). The IASB framework has a hierarchical system of principles that are headed by the objectives of IASB financial reporting, which is to provide the users of financial statements the information which could be useful in economic decision-making. The framework comprises basic principles and qualitative characteristics of financial information. The qualitative requirements are ‘relevance’, ‘understandability’, ‘comparability’ and ‘reliability’ (Delaney and Whittington, 2010, p.61). In order to eliminate the potential conflicts between the qualitative characteristics relevance and reliability, they are supplemented with subsidiary conditions, which are timely reporting, balance of benefit and cost, and balance of qualitative characteristics. Through these subsidiary conditions, the users of financial statements, prepared under IFRS, are likely to receive both reliable and relevant financial information. The qualitative characteristics are also supplemented by financial reporting principles, the capital maintenance concept and recognition and measurement principles. IASB framework is not an accounting standard as it does not override the provisions under IAS and IFRS. It only assists in development of the standards and accounting topics that lack guidance presently (Delaney and Whittington, 2010, p.61). Conclusion This essay has put forth the financial reporting framework and the role of qualitative characteristics of the financial information. There are a number of issues related to the qualitative characteristics. The materiality threshold is not easy to define and can be misunderstood. Therefore, ASB provides the guidelines as to how to determine the materiality of the items in financial statements i.e. on the basis of item’s size, nature and aggregation. The conflict between prudence and neutrality stems from the fact that prudence demands exercising judgement under uncertain conditions so that the assets and gains are not overstated, and liabilities and losses are not understated, which can result in biased estimates whereas neutrality requires bias-free financial information. IASB in its new conceptual framework has given priority to neutrality over prudence. Another conflict is considered between relevance and reliability because sometimes the most relevant information may not be more reliable and vice-versa. IASB has addressed the conflict by supplementing subsidiary information and financial reporting principles. This way the conflict between reliability and relevance has been tried to be minimized. Overall, an attempt has been made by the new framework to provide a clear view of the conflicting concepts. References Accounting Standards Board, 1999. Statement of Principles for Financial Reporting. [Pdf] Available at: http://www.frc.org.uk/documents/pagemanager/asb/Statement%20-%20Statement%20of%20Principles%20for%20Financial%20Reporting.pdf [Accessed 13 February 2012]. Delaney, P.R. and Whittington, O.R., 2010. Wiley CPA Exam Review 2011, Financial Accounting and Reporting, Volume 3. 8th ed. Hoboken, NJ: John Wiley and Sons. Deloitte Global Services Limited, 2012. IAS Plus: Framework for the Preparation of Financial Statements. [Online] Available at: http://www.iasplus.com/standard/framewk.htm [Accessed 13 February 2012]. Deloitte Global Services Limited-a, 2007. IAS Plus: IASB Agenda - Conceptual Framework Phase A Objective and Qualitative Characteristics. [Online] Available at: http://www.iasplus.com/agenda/framework-a.htm#dp [Accessed 13 February 2012]. Ernst & Young, 2008. International GAAP 2008: Generally Accepted Accounting Practice Under International Financial Reporting Standards. United Kingdom: John Wiley & Sons. IASC Foundation and IASB, 2008. A Guide through International Financial Reporting Standards. London: Kluwer. ICAEW, 2012. FRS 18: Accounting policies | Accounting standards | Library | ICAEW. [Online] Available at: http://www.icaew.com/en/library/subject-gateways/accounting-standards/uk-frs/frs-18 [Accessed on 13 February 2012]. Johnson, L.T., 2005. The FASB Report, Relevance and Reliability. [Pdf] Available at: http://zonecours.hec.ca/documents/A2007-1-1183240.Johnson_2005.pdf [Accessed 13 February 2012]. Lunt, H., 2009. CIMA Official Learning System Fundamentals of Financial Accounting. 6th ed. United Kingdom: Butterworth-Heinemann. McConnell, P., 2011. Patricia McConnell: The objective of financial reporting and the qualitative characteristics of useful information - what investors should know. [Online] Available at: http://www.ifrs.org/Investor+resources/2011+perspectives/January+2011+perspectives/objective+of+financial+reporting.htm [Accessed 13 February 2012]. Philipp, R., 2010. Wiley CPA exam review update 2011: what you need to know for the new exam format. Hoboken, NJ: John Wiley and Sons. Porter, G.A. and Norton, C.L., 2009. Financial Accounting: The Impact on Decision Makers. 6th ed. United States of America: Cengage Learning. Appendices Appendix 1: Conceptual Framework for Financial Reporting Source: (Kieso, Weygandt and Warfield, 2011, p.2-4) Appendix 2: Difference between Qualitative Characteristics of FASB & IASB Source: (Philipp, 2010, p.76) Read More