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Chapter1: Environment and Theoretical Structure of Financial Accounting

Qualitative Characteristics of Financial Reporting Information

Given the stated objective of financial reporting, what characteristics should information have to best meet the objective? Graphic 1-7 indicates the desirable qualitative characteristics of financial reporting information, presented in the form of a hierarchy of their perceived importance. Notice that the main focus is on decision usefulness the quality of being useful to decision making.—the ability to be useful in decision making.

 

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To be useful, information must make a difference in the decision process.

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GRAPHIC 1-7

Hierarchy of Qualitative Characteristics of Financial Information

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Fundamental Qualitative Characteristics

For financial information to be useful, it should possess the fundamental decision-specific qualities of relevance one of the primary decision-specific qualities that make accounting information useful; made up of predictive value and/or feedback value, and timeliness. and faithful representation. exists when there is agreement between a measure or description and the phenomenon it purports to represent. Both are critical. No matter how relevant, if information does not faithfully represent the appropriate economic phenomenon, it is useless. Conversely, information is of little value if it is not relevant. Let's look closer at each of these two qualitative characteristics, including the components that make those characteristics desirable. We also consider other characteristics that enhance usefulness.

 

To be useful for decision making, information should possess the qualities of relevance and faithful representation.

RELEVANCE.  Obviously, to make a difference in the decision process, information must be relevant to the decision. Relevance in the context of financial reporting means that the information must possess predictive valueconfirmation of investor expectations about future cash-generating ability. and/or confirmatory value,confirmation of investor expectations about future cash-generating ability. typically both. For example, if net income and its components confirm investor expectations about a company's future cash-generating ability, then net income has confirmatory value for investors. This confirmation also can be useful in predicting the company's future cash-generating ability as expectations are revised.

   This predictive ability is central to the concept of “earnings quality,” the ability of reported earnings (income) to predict a company's future earnings. This is a concept we revisit frequently throughout this textbook in order to explore the impact on earnings quality of various topics under discussion. For instance, in Chapter 4 we discuss the contents of the income statement and certain classifications used in the statement from the perspective of helping analysts separate a company's transitory earnings from its permanent earnings. This separation is critical to a meaningful prediction of future earnings. In later chapters, we look at how various financial reporting decisions affect earnings quality.

FAITHFUL REPRESENTATION. Faithful representation exists when there is agreement between a measure or description and the phenomenon it purports to represent. For example, assume that the term inventory in the balance sheet of a retail company is understood by external users to represent items that are intended for sale in the ordinary course of business. If inventory includes, say, machines used to produce inventory, then it lacks faithful representation.

   To break it down further, faithful representation requires that information be complete, neutral, and free from material error. A depiction of an economic phenomenon is complete if it includes all information that is necessary for faithful representation of the economic phenomena that it purports to represent. Omitting a portion of that information can cause the depiction to be false or misleading and thus not helpful to the users of the information.31

 

Faithful representation means agreement between a measure and a real-world phenomenon that the measure is supposed to represent.

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   Faithful representation also assumes the information being relied on is free from bias. Financial information should not influence decision making to achieve a predetermined result. In that regard, neutrality neutral with respect to parties potentially affected. is highly related to the establishment of accounting standards. You learned earlier that changes in accounting standards can lead to adverse economic consequences for certain companies, their investors and creditors, and other interest groups. Accounting standards should be established with overall societal goals and specific objectives in mind and should try not to achieve particular social outcomes or favor particular groups or companies.

   The FASB faces a difficult task in balancing neutrality and the consideration of economic consequences. A new accounting standard may favor one group of companies over others, but the FASB must convince the financial community that this is a consequence of the standard and not an objective used to set the standard.

   Uncertainty is a fact of life when we measure many items of financial information included in financial statements. Estimates are common. We would not expect all measurements to be error-free. However, the information should be free from material error if it is to be useful.

Enhancing Qualitative Characteristics

Graphic 1-7 identifies four enhancing qualitative characteristics, comparability (including consistency), verifiability, timeliness, and understandability.Comparability the ability to help users see similarities and differences among events and conditions. helps users see similarities and differences between events and conditions. We already have discussed the importance of investors and creditors being able to compare information among companies to make their resource allocation decisions. Closely related to comparability is the notion that consistency permits valid comparisons between different periods. of accounting practices over time permits valid comparisons among different reporting periods. The predictive and confirmatory value of information is enhanced if users can compare the performance of a company over time.32 In the Dell financial statements and disclosure notes, notice that disclosure Note 1 includes a summary of significant accounting policies. If Dell were to change one of these policies, new numbers might not be comparable to numbers measured under a previous policy. To be sure readers are aware of the change, Dell would need to provide a full disclosure in the notes to the financial statements.

 

Accounting information should be comparable across different companies and over different time periods.

   Verifiability implies a consensus among different measurers. implies a consensus among different measurers. For example, the historical cost of a piece of land to be reported in a company's balance sheet usually is highly verifiable. The cost can be traced to an exchange transaction, the purchase of the land. However, the fair value of that land is much more difficult to verify. Appraisers could differ in their assessment of fair value. The term objectivity often is linked to verifiability. The historical cost of the land is objective and easy to verify, but the land's fair value is subjective, influenced by the measurer's past experience and prejudices. A measurement that is subjective is difficult to verify, which makes it less reliable to users.

   Timeliness information that is available to users early enough to allow its use in the decision process. also is important for information to be decision useful. Information is timely when it is available to users early enough to allow them to use it in their decision process. The need for timely information requires that companies provide information to external users on a periodic basis. To enhance timeliness, the SEC requires its registrants to submit financial statement information on a quarterly as well as on an annual basis for each fiscal year.

 

Information is timely if it is available to users before a decision is made.

   Understandability users must understand the information within the context of the decision being made. means that users must understand the information within the context of the decision being made. This is a user-specific quality because users will differ in their ability to comprehend any set of information. The overriding objective of financial reporting is to provide comprehensible information to those who have a reasonable understanding of business and economic activities and are willing to study the information.




31Ibid., par. QC9.

32Companies occasionally do change their accounting practices, which makes it difficult for users to make comparisons among different reporting periods. Chapter 4 and Chapter 20 describe the disclosures that a company makes in this situation to restore consistency among periods.

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