The qualitative characteristics of financial information

The IASB’s Conceptual Framework for Financial Reporting

The IASB’s Conceptual Framework for Financial Reporting describes the basic concepts by which
financial statements are prepared. The main purpose of the Framework is to:

1. assist in the development of future IFRS and the review of existing standards by  setting out the
underlying concepts

2. promote harmonisation of accounting regulation and standards by reducing the number of

permitted alternative accounting treatments

3. assist the preparers of financial statements in the application of IFRS, which would include
dealing with accounting transactions for which there is not (yet) an accounting standard.

Qualitative Characteristics of Financial Information

For decisions to be made, the information must be relevant to the decision and be clearly presented,
stating any assumptions upon which the information is based, so that the user may exercise
judgement as appropriate.

The revised Framework distinguishes between two types of qualitative characteristics that are
necessary to provide useful financial information:

 Fundamental qualitative characteristics

- relevance and 
- faithful representation)

 enhancing qualitative characteristics 

- comparability (including consistency), 
- timeliness, 
- verifiability and 
- understandability).

Fundamental Qualitative Characteristics

For information to be useful, it must be both relevant and faithfully represented

1. Relevance

o Influences economic decisions of user

Relevant financial information is capable of making a difference in the decisions made by users

o Has predictive value and/or confirmatory value or both

Relevant information assists in the predictive ability of financial statements. 

That is not to say the financial statements should be predictive in the sense of forecasts, but that
(past) information should be presented in a manner that assists users to assess an entity’s ability to
take advantage of opportunities and react to adverse situations.
 o Materiality

Materiality is a threshold or cut-off point for information whose omission or misstatement could
influence the economic decisions of users taken on the basis of the financial statements.  

This depends on the size of the item or error judged in the particular circumstances of its omission or
misstatement.  

Hence, materiality is not a matter to be considered by standard-setters but by preparers and their
auditors.

2. Faithful Representation

General purpose financial reports represent economic phenomena in words and numbers. 

To be useful, financial information must not only be relevant, it must also represent faithfully the
phenomena it purports to represent. 

Financial statements will generally show a fair presentation when

• They conform with accounting standards

• They conform with the any relevant legal requirements
• They have applied the qualitative characteristics from the Framework.

Financial information that faithfully represents economic phenomena has three characteristics: -

 it is complete
 it is neutral
 it is free from error

Enhancing Qualitative Characteristics

Comparability, verifiability, timeliness and understandability are directed to enhance both relevant
and faithfully represented financial information. 

Those characteristics should be maximised both individually and in combination.

1. Comparability

o Users can identify similarities and differences

Comparability is fundamental to assessing the performance of an entity by using its financial

statements. 

Assessing the performance of an entity over time (trend analysis) requires that the financial
statements used have been prepared on a comparable (consistent) basis.

o Consistent application of methods

Comparability is enhanced by the use and disclosure of consistent accounting policies. 

Users can confirm that comparative information for calculating trends is comparable. 

The disclosure of accounting policies at least informs users if different entities use different policies.

Comparability should be distinguished from consistency (the consistent use of accounting methods).
It is recognised that there are situations where it is necessary to adopt new accounting policies
(usually through new Standards) if they enhance relevance and reliability. Consistency and
comparability require the existence and disclosure of accounting policies.

2. Verifiability

Financial information is verifiable when it enables knowledgeable and independent observers to

reach a consensus on whether a particular depiction of an event or transaction is a faithful
representation.

3. Timeliness

Timeliness means that information is available to decision-makers in time to be capable of

influencing their decisions.

4. Understandability

Understandability is enhanced when the information is:

o classified

o characterised

o presented clearly and concisely

However, relevant information should not be excluded solely because it may be too complex and
cannot be made easy to understand.

To exclude such information would make financial reports incomplete and potentially misleading.

Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyse the information with diligence.

The Cost Constraint on Useful Financial Reporting

Cost is a pervasive constraint to financial reporting. Reporting such information imposes costs and
those costs should be justified by the benefits of reporting that information. 

The IASB assesses costs and benefits in relation to financial reporting generally, and not solely in
relation to individual reporting entities. 

The IASB will consider whether different sizes of entities and other factors justify different reporting
requirements in certain situations.

Underlying Assumptions

The Framework sets out two concepts which can be presumed when reading financial statements:

 Accrual Basis

The effects of transactions and other events are recognised when they occur, rather than when cash
or its equivalent is received or paid, and they are reported in the financial statements of the periods
to which they relate.

 Going Concern

The financial statements presume that an enterprise will continue in operation in the foreseeable
future or, if that presumption is not valid, disclosure and a different basis of reporting are required.
Other Accounting Concepts

 The business entity concept (separate entity)

In accounting, a business should always be treated separately from its owner(s).

 Substance over form

Transactions need to be accounted for and presented in accordance with their substance and
economic reality even if their legal form is different.

 Fair presentation

The financial statements must "present fairly" the financial position, financial performance and cash
flows of an entity. 

Fair presentation requires the faithful representation of the effects of transactions, other events,
and conditions in accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Framework. 

IAS 1, “Presentation of Financial Statements” states that:

1. compliance with IFRSs should be disclosed

2. All relevant IFRS must be followed if compliance with IFRSs is disclosed

In some rare circumstances, management may decide that compliance with a requirement of an IFRS
would be misleading.  Departure from the IFRS is therefore required to achieve a fair presentation.

 Consistency

The same accounting principles should be used to prepare financial statements over a number of
periods

Underlying Assumptions

The Framework sets out two concepts which can be presumed when reading financial statements:

 Accrual Basis

The effects of transactions and other events are recognised when they occur, rather than when cash
or its equivalent is received or paid, and they are reported in the financial statements of the periods
to which they relate.

 Going Concern

The financial statements presume that an enterprise will continue in operation in the foreseeable
future or, if that presumption is not valid, disclosure and a different basis of reporting are required.

Other Accounting Concepts

 The business entity concept (separate entity)

In accounting, a business should always be treated separately from its owner(s).

 Substance over form

Transactions need to be accounted for and presented in accordance with their substance and
economic reality even if their legal form is different.
  Fair presentation

The financial statements must "present fairly" the financial position, financial performance and cash
flows of an entity. 

Fair presentation requires the faithful representation of the effects of transactions, other events,
and conditions in accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Framework. 

IAS 1, “Presentation of Financial Statements” states that:

1. compliance with IFRSs should be disclosed

2. All relevant IFRS must be followed if compliance with IFRSs is disclosed

In some rare circumstances, management may decide that compliance with a requirement of an IFRS
would be misleading.  Departure from the IFRS is therefore required to achieve a fair presentation.

 Consistency

The same accounting principles should be used to prepare financial statements over a number of
periods

IAS 1 states that for a fair presentation, the following is required:

1. selection and application of accounting policies

2. presentation of information in a manner which provides relevant, reliable, comparable and

understandable information

3. additional disclosures when required

Historical Cost

Historical cost has been defined as the amount paid or fair value of the consideration given.

Advantages of Historical Cost Accounting

 The cost is known and can be proved (e.g. against an invoice). It is therefore objective

 It enhances comparability

 It leads to stable pricing – using current market values would lead to volatility in asset values

Disadvantages of Historical Cost Accounting

 Non-current asset values are unrealistic

 Since non-current asset values are low, depreciation is low and does not fully reflect the
value of the asset consumed during the accounting year

 Lower costs, e.g. depreciation expense, would lead to higher profits. 

There is a possibility that this may lead to higher taxation, wage demands and dividend expectation
(based on overstated earnings per share). 

The combination of these effects is that a company may overspend or over distribute its profits and
not maintain its capital base.
  Comparisons over time are unrealistic

 Understatement of asset values tends to overstate gearing, and leads to a low asset per
share value and can make the company vulnerable to a take over

 Where assets, particularly land and buildings, are being used as security to raise finance, it is
current value that lenders are interested in, not historical values

These disadvantages usually arise in times of rising prices. In fact, in times of rising prices, historical
cost accounting tends to understate asset values and overstate profits.

Prudence

The Conceptual Framework views prudence as a component of neutrality, which is a characteristic of

faithful representation. 

Prudence is described as:

'the exercise of caution when making judgements under conditions of uncertainty. The exercise of
prudence means that assets and income are not overstated and liabilities and expenses are not
understated.‘

As an accountant, it is important to exercise caution when making accounting estimates.