Qualitative Characteristics of Financial Information

Question:

Discuss about the Qualitative Characteristics of Financial.

Conceptual framework is an accounting theory prepared by the regulatory body of accounting standard setters which can be used to solve the practical issues of financial reporting. The general purpose financial statements are aimed at imparting the financial information to the intended users, especially, the current and potential investors as they are the external parties and hence are not involved in the preparation and presentation of reports. These parties play important role for an entity as they invest huge amount of funds in it. To take critical decisions about their investments they require entity’s financial reports. Financial information is the organised form of raw accounting related data that is presented in the financial terms for the purpose of financial reporting requirements. While making the presentation of such significant information in the financial reports an entity’s professional accountant has the statutory duty to fulfil the requirements of conceptual framework of accounting (IASB, 2010). The framework on financial reporting prescribes certain qualitative characteristics which the information contained in the financial reports must possess. As significant decisions are made using such information it is necessary that it is reliable, relevant, understandable and comparable. These features increases the overall quality of the financial reports of the entity. If the information is not carrying the prescribed qualities it may not reflect the true picture of company’s financial situation which misleads the intended users. An information is called relevant when it has the capability of the influencing the decisions of intended users. The relevant quality of the information must provide it the predictive value and confirmative value (Birt, Muthusamy & Bir, 2017) (Jones & Smith, 2011). Also, the information must be reliable so as to be used by the users in understanding the financial performance as well as the situation of the reporting entity. Reliability of the information is generated when it is faithfully represented in the financial statements (Collier, 2015). Both the relevance and faithful representation are fundamental qualitative characteristics of financial information. However, the requirement of information’s faithfulness can be considered as more important as in comparison to the relevance feature. Even if the relevant information is disclosed in the statement and reports but if is not free from material errors or is no complete in the holistic manner than it would not be useful to the readers. The term faithful representation has replaced the term reliability as was used previously. It requires the financial statements to depict accurate information of the company’s business. This feature of information must be applied to all the significant parts of financial statements like results of operating segments, company’s financial position and the entire cash flows of the company (Kadous, Koonce, & Thayer, 2012).The information that possess faithfulness as its characteristics will have mainly three aspects. First, the information must be free from any kind of bias treatment and hence it must be neutral. The neutrality concept requires the preparers of financial reports to present the financial statements in such a way that it reflects the true position of reporting entity without inflating its profitability merely to make it attractive or to gain some undue advantages. Unbiased accounting treatment is necessary to promote and maintain the greater level of transparency of the company’s operations. Second, the information is considered as faithful when it is free from material that means the reports must not contain any errors either in terms of presentation or in calculation (Lusardi Mitchell & Curto, 2010). Only if the information is accurate then it will reflect the true and fair view of company’s financial situation. The relevant information if not correctly prepared or presented may impair its ability to influence the thought process of its investors (Kargin, 2013). Third, the information must be complete in each sense as an incomplete information can lead the investors or potential investors to take inappropriate decisions about the company. An information is reliable only when it faithfully represents all the necessary events and transactions of entity’s operations. If the information holds influencing power by nature but is not represented or disclosed in the reliable manner than it would not be able to serve its purpose (Nobes & Stadler, 2015).

Importance of Faithful Representation in Financial Reporting

Given the nature of accounting standard setting it is not possible for the preparers of financial reports to achieve the quality of faithful representation because of the inherent uncertainties, assumptions and estimates made in accounting. These factors might not always allow the financial information to be free from material errors. Hence, it would be difficult for the preparers to achieve this feature. However, if any omission or error does not affect the explanation of economic phenomena of financial information and the processes that have been used in producing the reported information are selected and applied with no errors the faithfulness can be still be achieved.

Normative theories of accounting are those theories that are not based on the observations rather they based formed on the basis of the ways that tells how accounting operations are undertaken. These theories are believed to use various differing methodologies to ultimately find the best and suitable accounting opinion. They use few formulas to determine business income based on the values and not on the costs. Historical cost is the aggregate of prices paid by the company to acquire and install the asset to make it available in the working condition. The approach that Historical cost accounting follows is based on the actual cost incurred in acquiring the ownership of asset and under this accounting the same cost is disclosed in the balance sheet of the firm (Greenberg, et.al, 2013).

There are certain strengths and weaknesses of this concept. Its strengths includes the objectivity provided it as the financial statements are not affected by the increase and decrease in the values of its elements. So it avoids the chances of data manipulation. Further, this method of accounting is quite convenient and simple to be implemented in comparison to the other methods of valuation. Moreover, the use of historical cost accounting promotes the level of consistency of financial statements making it easier for the readers to compare the information with other related data.

At the same time HCA suffers from various limitations which affects its usability such as it does not consider change in prices leading to overstatement of profits in inflationary times. Further, this approach impairs the current operating results of the company by making inclusions of holding gains which were accrued in last years, in the income of current year. Moreover, this approach contributes to misleading financial statements (Coetsee, 2010). There are several accounting theories which are advanced as the alternatives to accounting historical cost was holding many limitations especially in case of rising prices. As this particular accounting works on the assumption that money always holds a purchasing power that remains constant. Below is the discussion of alternative normative theories of historical cost approach of valuation:

Alternative Normative Theories of Historical Cost Approach of Valuation

This accounting model was approved by IASB (international board for accounting standards) and was advanced as an alternative to the accounting based on historical cost. It has the view that in the rising price times i.e. in inflation, if entity distributes the unadjusted profits on the basis of historical costs it would amount to reduction in the entity’s real value. Therefore, under this approach the financial statements prepare on historical cost basis will be restated to incorporate the changes in purchasing power of public and the adjusted statements would represent the original amounts on the basis of purchasing power of the current time.

Current cost accounting is another alternative normative theory to the historical cost accounting. This concept separates the profits from trading activities from the gains arising from holding the assets. This concept considers the changes in the prices to a specific firm or industry instead of taking into account the entire economy. It seeks arriving at the profit which are distributable without having any adverse impact on the operational capacity of the entity (Zhang & Andrew, 2014).Unlike historical cost accounting, current cost accounting considers valuing assets at the price which was required to be paid currently if the assets were to be purchased currently (BESSONG & CHARLES, 2012). This concept of accounting relies mainly on the use of indices and also it is easier to be applied to the particular assets of the firm.

This approach helps in providing the information in relation to company’s capability to adapt itself in the present conditions. Unlike historical cost accounting, CoCoA assumes that the money’s purchasing power does not remains constant and keeps on changing. Under this accounting the assets and liabilities are measured at their existing cash price.

This type of accounting does not use a particular cost to value assets rather it uses the value which is acceptable generally between the potential buyers and sellers of the assets. It may sometimes represent current cost or net realisable value or net present value depending upon the situations.

Modified Historical Cost Accounting (MHCA): this concept is permitted by companies act. Under this method certain assets are incorporated in the financial statements at the revalued amount instead of recording them at their historical cost.

The fair value accounting and current cost accounting has gained much of considerations and are both are being implemented most commonly by the entities to measure their assets and liabilities of the business. These approaches evaluates the current position of the business by valuing the important elements of it on the current values.

Conceptual framework of accounting has been introduced by the international board of accounting standards. It deals with the fundamental issues of financial reporting like necessary characteristics of financial information, objectives of financial statements, main aspects of financial assets and the concepts of identifying and measuring the basic elements of financial statements. The key building blocks of conceptual framework of accounting are given as follows:

Financial Reporting Definition: This section of the framework draws the scope of financial reporting. It considers the activities that needs to be embraced in the financial reporting discipline.

Reporting entity: This area is administered by SAC 1 and it is concerned with the determination of criteria to identify the reporting entities which are required to prepare financial reports.

Objectives of financial reporting: This area of framework sets out the main objectives that the financial reporting must achieve. It defines the users of the financial reports and also the kind of information they need. This part is administered by SAC 2.

Qualitative characteristics: This section is addressed by SAC 3 and deals with identifying and defining the qualitative characteristics of financial information which it should possess to achieve the purpose of financial reporting.

Financial statement Elements & Recognition of basis: This block of conceptual framework primarily deals with the basic aspects of financial statements such as equities, reserves, incomes and expenses, assets and liabilities. This part is also concerned with identifying defining and establishing the recognition criteria of the main elements to be included in the financial statements. This block is assessed by SAC 4.

Perceived users of financial statements: The users are the ones who reads the financial reports of the reporting entity to make their decisions in relation to the matters in which they are associated with the company. They are mainly the shareholder and investors of the company.

Measurement basis & Measurement techniques: This block defines the techniques of measuring the basic elements of the financial statements. It also explores the alternative attributes of measurement such as historical cost, cash equivalents, current costs etc. Moreover, it sets out the basic measurement units of the elements. There are other building blocks like financial position, Performance, Change in financial position, compliances.

There are various advantages for accounting that can be resulted from the development of the conceptual framework of accounting. The framework offers accounting standard board with the base for setting accounting standards and also the concepts to be used as tools to resolve the accounting and reporting related queries. It helps in guiding the standard setters in development of financial reporting norms and regulations (Weygandt, 2010).It also helps the readers of the financial information to understand the information and its limitations in the better way. It offers precise definitions of certain terms to be used in the accounting. Moreover, the auditors can use such framework to resolve the financial reporting issues.

The conceptual framework of financial reporting has been severely criticized for not offering an adequate basis for setting accounting standard (Christensen, 2010). Its implementation is difficult to by the developing countries as it quite time consuming and is too expensive. At the same time this framework is highly criticized for its rigidity. Moreover, the framework only considers the qualitative characteristics of financial information. Due to all these inefficiencies the conceptual framework requires to be altered. The framework provided by FASB was also criticized for not requiring the entities to report the necessary and interpretable information to the users of financial statements (FASB, 2010).

Further, the framework is also criticized for not providing conformity between the previously used accounting standards before the introduction of conceptual framework of accounting. Also, the critics of conceptual framework has also been arguing that the accounting standards are getting overly rules based which are leading to its inefficiencies ((Wells, 2011).

No, it would not be appropriate for me to agree with the criticism as the critics are not considering the most critical viewpoint of the conceptual frameworks. The perspective of users of financial reports have been duly emphasised by the accounting framework. From the user’s point of view the conceptual framework is quite adequate as it considers the reliance of users i.e. existing and potential investors and other stakeholders of the company on its financial reports for the purpose of decision making. The characteristics of financial information that the existing conceptual framework provides takes into account the general attitude of the person while interpreting and understanding the financial reports. Therefore, the criticism made by several critics are not acceptable.

References:

Australian Government, (2001). Qualitative Characteristics of financial information: SAC 3, available at https://www.aasb.gov.au/admin/file/content105/c9/AASB112_07-04_COMPsep11_07-12.pdf (viewed on 9^th October, 2017).

BESSONG, P. K., & CHARLES, E. (2012). Comparative Analysis of Fair Value and Historical Cost Accounting on Reported Profit: A Study of Selected Manufacturing Companies in Nigeria. Research Journal of Finance and Accounting, 3(8), 132-149.

Birt, J.L., Muthusamy, K. and Bir, P. (2017). XBRL and the Qualitative Characteristics of Useful Financial Information. Accounting Research Journal, 30(1).

Christensen, J. (2010). Conceptual frameworks of accounting from an information perspective. Accounting and Business Research, 40(3), 287-299.

Coetsee, D. (2010). The role of accounting theory in the development of accounting principles. Meditari: Research Journal of the School of Accounting Sciences, 18(1), 1-16.

Collier, P.M., 2015. Accounting for managers: Interpreting accounting information for decision making. John Wiley & Sons.

  Conceptual frameworks of accounting from an information perspective. Accounting and Business Research, 40(3), 287-299.

Financial Accounting Standards Board (FASB), (2010). Conceptual Framework for Financial Reporting: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. Statement of Financial Accounting Concept No. 8.

Financial Accounting Standards Board (FASB). (2010). Conceptual Framework for Financial Reporting: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. Statement of Financial Accounting Concept No. 8.

Greenberg, M. D., Helland, E., Clancy, N., & Dertouzos, J. N. (2013). Fair Value Accounting, Historical Cost Accounting, and Systemic Risk. Rand Corporation.

IASB, C. F. (2010). The Conceptual Framework for Financial Reporting, as in September 2010. International Accounting Standards Board, London, UK.

Jones, D.A. and Smith, K.J. (2011). Comparing the value relevance, predictive value, and persistence of other comprehensive income and special items. The Accounting Review, 86(6), pp.2047-2073.

Kadous, K., Koonce, L., & Thayer, J. M. (2012). Do financial statement users judge relevance based on properties of reliability?. The Accounting Review, 87(4), 1335-1356.

Kargin, S. (2013). The impact of IFRS on the value relevance of accounting information: Evidence from Turkish firms. International Journal of Economics and Finance, 5(4), 71.

Lusardi, A., Mitchell, O. S., & Curto, V. (2010). Financial literacy among the young. Journal of consumer affairs, 44(2), 358-380.

Nobes, C. W., & Stadler, C. (2015). The qualitative characteristics of financial information, and managers’ accounting decisions: evidence from IFRS policy changes. Accounting and Business Research, 45(5), 572-601.

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Weygandt, J. J., Kimmel, P. D., KIESO, D., & Elias, R. Z. (2010). Accounting principles. Issues in Accounting Education, 25(1), 179-180.

Zhang, Y., & Andrew, J. (2014). Financialisation and the conceptual framework. Critical perspectives on accounting, 25(1), 17-26.