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The qualitative characteristics of financial information

Users who make economic decisions based on financial statements need these financial statements to provide information which is useful to them. To make sure that financial statements provide useful information to users, the ASB’s statement of principles chapter three which is titled the qualitative characteristics of financial information sets out the desirable characteristics of financial information. In chapter three the ASB set out five main qualities that are required of financial.

The first one is materiality, which is threshold quality, its purpose is to make sure that any information that is given dosen’t impair the usefulness of the other information given. The other four qualities relevance, reliability, comparability and understandability. We shall now look at each qualitative characteristics in turn. The first characteristic of information is relevance. The definition of relevance is as follows: Information is relevent if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions.

(SP, 3. 2) The above definition has its basis in a key feature of the objective of financial reportring, that is information is provided to aid decision-making and is valued for its ability to do so. Relevance isn’t defined by whether it actually influences

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decisions but by the capacity to influence decisions. Relevance is based on two characteristics, unformation to be relevant needs to at least one of the characteristics. The two characteristics are predictive value and confirmatory value.

Financial information should have predictive value if it helps users to evaluate or assess past, present or future events. Investors’ buying and selling decisions essentially need an entity’s capacity to generate financial surples and associated net cash flows, as this determines the entities ability to pay dividends, and this ability to pay will determinte the entities share price. Users may also want evaluate other aspects of the entities future such as the changes in production capacity.

Financial informations should have confirmatory value if it helps users to confirm their past evaluations. The information received from users will tell users what has actually happened in the past, and users can compare this information with their own forecasts to see if events have turned out as forecasted or have differed. So therefore the two characteristics of relevance ‘are interrelated because of the cyclical character of both the entity’s earnings and cash generating processes and the investors process of evaluation. ‘1 The second main characteristic of information is reliability.

Read also about Threshold Capabilities

The definition of reliability is as follows: Information that is a complete and a faithful representation of the entity’s actions There are five characteristics of reliable information. These are: Firstly, the information can be depended upon to represent faithfully what it either claims to represent or could reasonably be expected to represent. Faithful represtation is tested against the specific claim within the information itself about what is represented and other interpretations a user will reasonablymake of whatis represented.

Secondly, the information is free from deliberate or systematic bias (i. e. it is neutral). To do this the gap between depiction and the underlying reality should be ensured that it is not deliberately baised in one direction rather than another so that users of the information are misleadpurposely. Thirdly, the information is free from material error. Fourthly, the information is complete within the bounds of materiality. Fifthly and finally, the information is prudent (i. e. not creating hidden reserves or excessive provisions etc. ).

The information is prudent when disclosure of the naure and extent of the uncertainty in the information and that cauation has been applied in making estimates of accounting numbers, so they are not overstated or understated. The third main charateristic of information is comparability. Users of financial information are trying to compare the underlying realities of the various entities they are studying and the users usually use financial information to do this. Comparability split into dimensions:comparability through time and comparability between entities.

To enable users to make comparisons. ‘information needs to be prepared and presented in a way that enables users to discern and evaluate similarities in, and differences between, the nature and effects of transactions and other events taking place over time and across different reporting entities. ‘(SP, 3. 22) The statements of Principles identify two main ways that comparability can be achieved. These are consistency and disclosure of accounting policies. Consistency is treating like events in a like manner.

Part of this is meauring and displaying events in the same way. Also consistency extends to matters about classification and display. Users need to know that the information is consistent and how to react to inconsistencies in the information. For this to happen campanies need to disclose accounting policies they use and changes in policies and the effect of such changes. The fouth main characteristic of information is understandability. If users cannot perceive the significance of information they will not be able to use it appropriately.

Understandability can be split up into two parts – the way items in the information are aggregated, classified and presented – and in part on the capabilities of the user. The accountanting ability that can be assumed in users of financial information is a crucial in designing the financial statements. Users of financial statements are likely to have a wide range of abilities,varying from limited skills of amatuers to high skilled investors and financial analysts. A problem arises with the varying abilities of users. The problem is, that financial statements need to provide information that nai??

ve users can understand but also providing the sophisticated and complex information that skilled investors or financial analysts need. To resolve this problem a policy decision has to be made as a social choice by policymakers rather following the conceptual framework. The Statement of principles choice is descibed in the passage below: ‘Those preparing financial statements are entitled to assume that users have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided. ‘ (SP, 3. 27)

This does imply that financial statements can assume reasonably sophisticated users. The fifth and final main charateristic of information is materiality. The idea of materiality is one of a threshold quality and any item that is not material does not require to be considered further. The statement of principles the idea of a threshold qulity as: ‘An item of information is material to the financial statements if its misstatement or omission might reasonably be expected to influence the economic decisions of users of those financial statements, including their assessment of management’s stewardship.

‘ (SP, 3. 30) ‘First, this means that is justified not to report immaterial items which would impose unncessary costs on preparers and impede decision-makers by obscuring material information with excessive detail. ‘2 ‘Second, it means that the important consideration is not user expectations (e. g. they might expect turnover to be accurate to within 1%) but the effect on decision-making (e. g. there might only be an effect if turnover were to be more than 10% overstated or understated, in which case onlt errors exceeding 10% are material). ‘3

‘It also states that ‘Materiality depends on size of the item or error judged in the particular circumstances of its omission or misstatement’. The need to excerise judgement means that the preparer needs to have a benchmark. ‘4 So in theory, the expectation is that accounting regulators will select that accounting method which best satisfies all of the above critera. Before this can happen the Accounting Standards Board believes that to a gain a better view of the qualitative characteristics there needs to be a consideration of the interretalionships between the qualitative characteristics.

But the study of the interrelationships between the characteristics show there are conflicts between the qualitative characteristics so that gaining more of one charateristic will reduce the level of one or more of the other characteristics. So it is necessary to decide the balance between the pursuit of the individual qualitative characteristics. The Statement of Principles puts it: “On occasion, a conflict will arise between the characteristics of relevance, reliability, comparability and understandability. In such circumstances, a trade-off needs to be found that still enables the objective of financial statements to be met.

‘ (SP, 3. 33) ‘Conflicts between criteria complicate considerably the problem of choosing the most useful accounting method. But if a conceptual framework is to have practical relevence, some way must be found of resolving these conflicts. ‘5 The ASB have identified relevance and reliability as the key characteristics of financial statements for them to be useful. This means that ‘once information has been identified as relevent and reliable, it should be presented to users in a way that enhances comparability and ensures that a reasonably diligent user will be able to understand it.

‘6 Materiality is the ‘threshold’ quality, in that if the information is not matrial, it dose not need to be considered further. Therefore the two primary characteristics of financial information are relevence and reliability. Comparability and understandability are also important, but secondary, as characteristics of financial information. Information which is lacking in either comparability or understandability would be of limited usefulness, however relevant and reliable it was. But there is conflict between relevence and reliability.

To solve this the ASB in the Statement of Principles have said that where there is conflict between relevance and reliability, ‘it will usually be appropriate to use the information that is the most relevant of whichever information is reliable’ (SP, 3. 1). In conclusion then, the Statement of Principles gives a explanation of the qualitative characteristics of financial information and some hints, as to the way the conflicts between the characteristics are to be resolved. ‘Both the definitions of the qualities and the framework for resolving conflicts are expressed in generalised and abstract terms.

As such, they help to focus and move forward the debate about the specification of financial statements but do not provide an operational mechanism for dealing with concrete problems, including, for example, the need to establsh tradeoffs between the various qualities and components of those qualities. These will continue to have to be dealt with by judgement in individual cases and whetheror not the scheme will be of assistance at this level remains to be seen. ‘7 Also the Statement of Priciples lists cost benefit as one of the factors that ASB takes into account in setting standards.

Applying a cost-benefit analysis is seen to be an important part of the standard-setting process. ‘The benefits from improvements in financial information flow through primarily to the users of the information (in terms of better decisions), though there may also be social benefits from improvements in the allocation of resources and in spurring managers to improve performance. The costs of reporting improved financial information include any incremental resources used to generate and audit the new information compared with what was periously reported; any incremental resources used in disseminating the information (…

) ; potental damage to the reporting entity’s commercialposition because competitors will also obtain the information; and the costs involved in absorbing and analysing the new information. ‘8 When appyling the qualitative characteristics and the cost-benefit analysis should be kept in mind that different users, even within a single user group, will in theory, seek different trade-offs between the qualitative characteristics and a different balance between costs and benefits.

Finally the use of Prudence in the Statement of Principle has been critcised. Some people comment that it does not go far enough in asserting the impotance of providing unbiased information. For others, the traditional approach is preferred: ‘Prudence [as defined by SSAP2] is a mainstay of traditional practice. The Prudence concept creates an essential bias . . . a potent antidote to counteract preparers’ eternal optimism.

References

1 ‘An introduction to modern financial reporting theory.’ Brian A. Rutherford.

2 ‘Financial Accounting and Reporting’ 8th edition, Barry Elliott and Jamie Elliot.

3 ‘Financial Accounting and Reporting’ 8th edition, Barry Elliott and Jamie Elliot.

4 ‘Financial Accounting and Reporting’ 8th edition, Barry Elliott and Jamie Elliot.

5 ‘Finacial accounting’ 2nd edition, Arnold, Hope, Southworth and Kirkham.

6 ‘Finacial accounting’ 2nd edition, Arnold, Hope, Southworth and Kirkham.

7 ‘An introduction to modern financial reporting theory.’ Brian A. Rutherford.

8 ‘An introduction to modern financial reporting theory.’ Brian A. Rutherford.

9 Davies and Davies,1996: 89.

Biblography

‘An introduction to modern financial reporting theory.’ Brian A. Rutherford.

‘Financial Accounting and Reporting’ 8th edition, Barry Elliott and Jamie Elliot.

‘Finacial Accounting’ 2nd edition, Arnold, Hope, Southworth and Kirkham.

‘Advanced Financial Accounting’ 7th edition Lewis and Pendrill.

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