Introduction

This article is part three in the series on the Conceptual Framework, as promulgated by the International Accounting Standards Board (IASB). Part one can be found here; part two can also be found here. You might want to read the first two parts before diving into this one.

That said, in this article, Chapter two of the Framework will be discussed. The official title of the Chapter is Chapter 2 – Qualitative Characteristics of Useful Financial Information (IASB, 2018, p. A20).

Chapter 2 is broadly divided into three (3) sections:

1. Introduction – starting from para. 2.1
2. Qualitative Characteristics of Useful Financial Information – starting from para. 2.4
3. The Cost Constraint on Useful Financial Information – starting from para. 2.39

What kind of financial information is useful?

Useful financial information is marked as such by the qualitative characteristics it possesses. From a reading of para. 2.4, it can be deduced that different sets of financial information can vary in their usefulness for decision making.

The Board notes that all sets of useful financial information possess two (2) Fundamental Qualitative Characteristics (FQCs). These are relevance and faithful representation.

That said, a set of financial information may be more useful, compared to another, because it possesses what the Board refers to as Enhancing Qualitative Characteristics (EQCs). The Board lists the four (4) as: comparability, verifiability, timeliness and understandability.

Relevance

Relevant information is one which can cause a decision to change. For a piece of information to be capable of such a change, the Board says it must have either Predictive Value, or Confirmatory Value, or it must have both of these characteristics.

The Predictive value of a piece of information refers to its ability to be employed as an input in a process by the user, which then spits out an output in the form of a prediction. This is distinct from confirmatory value, which is a piece of information’s ability to show that a previous assessment or evaluation was true; or that it was false, and as such needs to change.

The Board notes in para. 2.10, that both of these attributes of relevant information are interrelated. Information with predictive value often also has confirmatory value.

As an example, if a user predicts what the revenue of an entity is likely to be in the future, using revenue information for the current year, it means that the revenue information for the current year has predictive value. In the same way, the current year’s revenue can be compared to a prediction that was made in the past, of what the current year’s revenue was going to be. This comparison can be used to improve the predictive process the user employs. Hence, the current year’s revenue information has confirmatory value.

Aside all the above, the discussion around relevant information tends to bring up what is known in financial reporting as the issue of “materiality”. This is discussed in para. 2.11. A piece of financial information is said to be material if “omitting, misstating or otherwise obscuring it could reasonably be expected to influence the decisions that the primary users of general-purpose financial reports make on the basis of those reports…” (IASB, 2018, p. A22).

It is worth noting that materiality is not just about how big or small a particular figure is, in the financial reports. The mere nature of a piece of financial information can make it material. For instance, in any company, the remuneration of directors is considered material information, regardless of amount. It needs to be disclosed because of the significant influence directors wield on a company. Hence, materiality is described by the Board as “an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates…” (IASB, 2018, p. A22).

As a result of the nature of the concept of materiality, the Board is unable to specify what a uniform quantitative threshold should be for materiality. It cannot also predetermine what should be material in what situation.

Faithful representation

In para. 2.12, we see what the nature of financial reports are—they represent economic phenomena in words and numbers. That said, the substance of these economic phenomena must be faithfully represented if they are going to be of any use to users.

The catch is this: that the substance of an economic phenomenon, is often different from its legal form—though sometimes legal form and economic substance are the same. In light of this, it can be surmised that providing information, only on just the legal form of an economic phenomenon is unlikely to faithfully represent that economic phenomenon. Faithful representation of the substance of the transaction is what will get the job done.

A perfectly faithfully represented economic phenomenon has three characteristics: it should be complete, neutral, and error-free. The Board acknowledges that perfect faithful representation is seldom achievable, if ever. However, it is something which should be aspired to; and this can be done by the maximisation of these characteristics of completeness, neutrality and ensuring the information is error-free.

Completeness of financial information means that, all the necessary information to allow a user understand the phenomenon being depicted are included in the depiction. Neutrality on the other hand, means that the depiction, in selecting what kind of financial information to include or exclude, is without bias. The information must not be manipulated to increase the probability that users will will view it favourably or otherwise.

The Board notes in para. 2.16, that neutrality is supported by the exercise of prudence. Being prudent means, that in making judgements under conditions of uncertainty, Accountants must exercise caution. This means making sure not to either understate or to overstate a piece of financial information.

Lastly, Free from error refers to freedom from error in two ways:

1. There are no errors or omissions in the description of the phenomenon.
2. The process used to produce the information is selected and applied with no errors in the process.

In para. 2.18, the Board makes sure to clarify that faithful representation does not mean accuracy in all respects. It means rather, that there must not be an error or omission in the description of the financial information, or in the selection and application of the process which was used to produce the reported information.

As an example, there some classes of things whose prices cannot be found on a market. In such cases, the relevant prices and/or value need to be estimated. In such a case, one cannot make a determination on the accuracy, or otherwise, of its price. Nevertheless, a faithful representation can be made of the estimated price if the amount is described clearly and accurately as being an estimate. In addition, the nature of the processed used in making the estimate, and its limitation, if explained, will make this a faithful representation. That is, if no errors have been made in selecting and applying an appropriate enough process for making this estimate. And furthermore, if the nature of the process used in making that price estimate, as well as its limitations are clearly and accurately described and explained.

Such situations occur quite often in financial reporting. In those situations, it is said that, there has arisen a measurement uncertainty. This is an integral part of financial reporting, and in no way undermines the usefulness of the information, assuming estimates are clearly and accurately described and explained. Nevertheless, this means (in some cases) making trade-offs between FQCs in order to meet the objective of financial reporting which is to provide useful information about economic phenomena. Sometimes the most relevant information may be one with a highly uncertain estimate, which may affect its faithful representation.

The enhancing qualitative characteristics

EQCs are characteristics of financial information which “…may help determine which of two ways should be used to depict a phenomenon if both are considered to provide equally relevant information and an equally faithful representations of that phenomenon.” (IASB, 2018, p. A24)

Comparability

This is the first of the EQCs. A piece of information is more useful if it allows for comparisons to be made, as users decisions often involved making choices between and amongst alternatives. For instance, one piece of financial information, might be compared to another similar piece of financial information about another entity, or perhaps with another similar piece of financial information about the same entity, but for another period or date. Thus, the ability to compare any piece of financial information to another, makes that information more useful.

The Board was clear in para. 2.26 to distinguishing consistency from comparability, although they are related. The Board notes that Comparability is the goal: and Consistency helps achieve that goal. However, Consistency refers to the use of the same methods for the same things from period to period, or in the same period, but across different entities. It enables comparability of financial information.

The Board also makes clear what comparability is not. It is not uniformity. For comparability to be possible, like things must look alike, and different things must look different. This allows for comparison and spotting of differences as well as nuances. Therefore, if unlike things are forced to look alike, it does not enhance the comparability of financial information any more than trying to make like things look different.

The Board also notes that a phenomenon can be faithfully represented in a couple of ways. However, if alternative accounting methods were to be allowed for the same phenomenon, comparability diminishes.

Verifiability

Verifiability is that enhancing qualitative characteristic which provides assurance of faithful representation. It simply means that different people, who are usually independent of each other, could reach a consensus that a depiction made by an accountant, is a faithful representation. For verification purposes, the Board states in para. 2.30, that quantified information does not need to be a single estimate. A range of possible amounts and their related probabilities can also be verified.

Furthermore, verification can be direct or indirect: Direct when it can be physically observed. For instance, counting cash which an entity says they have, in order to verify that they indeed have that amount; and then indirect when the inputs used to arrive at a certain output can be obtained and then employed in the same process to arrive at the same output. Basically, this is where verification is done by way of a recalculation of relevant amounts. The valuation of Inventory of an entity can be checked this way.

Timeliness

Timeliness is an enhancing qualitative characteristic which has to do with making the information available to users in good time, such that the information is capable of influencing their decision. The Board notes in para. 2.33, that in general, the older the information, the less useful it is. Nevertheless, some information may continue to be timely long after the end of a reporting period. This could be because some users may employ the information in trend analysis.

Understandability

The Board states in para. 2.34, that classifying, characterising and presenting information clearly and concisely makes it understandable.

Sometimes financial information can be complex and difficult to understand, however, excluding such information from financial reports may make those reports incomplete and otherwise misleading. This is the case, even though, such a move might make the financial information more understandable.

The Board notes that, this might mean users may need to employ the services of an advisor to understand the relevant information.

How EQCs should be applied in Financial Reporting

The Board’s view on EQCs, as set out in para. 2.37 is that they should be maximised to the extent possible.

That said, preparers of financial information must note that the EQCs (taken individually, or together as a group) cannot make a piece of financial information which does not posses FQCs useful. That is, any information which is irrelevant and/or is not faithfully represented is already useless information for financial reporting purposes— an EQC cannot unmake that.

The Board notes that, the application of EQCs is an iterative process without a prescribed order, where trade-offs may have to be made. An increase in one EQC may lead to the diminishing of another.

As an example, sometimes comparability may be temporarily diminished when a new accounting standard comes into force and an entity applies it starting in a particular financial year, but does not go back to retrospectively make amendments to financial statements of previous years. The effect of this is that current financial statements may not be directly comparable to previous year financial statements.

The Board notes that this kind of situation may be the case, and may occur. And this is because by applying the provisions of the new standard, relevance and faithful representation will be increased into the longer term.

Cost constraint on useful financial information

The Board notes in para. 2.39, that cost constrains financial reporting, and in a pervasive way. This means that whatever financial information an entity decides to provide, there is automatically associated with that decision, a cost. It is costly to report financial information.

In light of this, the Board says that it is important to make sure that the benefits of providing that kind of information, outweighs the costs involved in making that financial information available.

Now, with respect to costs, even though the entity expends the most effort and resources in collecting, processing, verifying and disseminating financial information, it is worth noting that users are the ultimate bearers of that cost. They bear that cost in the form of reduced returns.

Apart from prospective reduced returns, users bear several other costs. For instance, the cost of analysing and interpreting financial information. This could happen when the user needs to employ the services of an expert. Additional costs may also be incurred, assuming the entity does not make some piece of financial information available and the user has to now obtain it from other sources.

As for benefits, relevant and faithfully represented information allows for the making of decisions with confidence. The Board says this leads to the efficient functioning of capital markets as well as lower cost of capital for the economy as a whole.

Given these benefits and costs, the Board  makes sure that in coming out with any standard or amendments, the requirements on entities to provide pieces of financial information are done in light of this cost-benefit analysis. That is why the Board consults broadly with industry as well as other key stakeholders such as auditors, academics, users among others, before the promulgation of any new pronouncements— usually standards.

Conclusion

In this article, part three in the series, an attempt has been made to cover Chapter 2 of the Conceptual Framework for financial report as promulgated by the IASB in March 2018.

This was basically the detailing and explanation of what Fundamental Qualitative Characteristics (FQCs) and Enhancing Qualitative Characteristics (EQCs) and how they are to be applied in Financial Reporting.

The key takeaway is that all financial information must be relevant and must be faithfully represented. After that has been achieved, the preparers, in making decisions between what kinds of information to include, should choose those pieces of information which possess greater EQCs.

In future parts of this article, the other Chapters of the Conceptual Framework as promulgated by the International Accounting Standards Board will be discussed in detail.

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References

IASB. (2018). Conceptual Framework for Financial Reporting. London: IFRS Foundation. Retrieved from http://eifrs.ifrs.org/eifrs/PdfAlone?id=24380&sidebarOption=UnaccompaniedConceptual