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The conceptual framework identifies fundamental and enhancing qualitative characteristics of useful information.
The fundamental characteristics are
- relevance and
- faithful representation.
The enhancing characteristics are
- comparability,
- verifiability,
- timeliness, and
- understandability.
Fundamental Characteristics
Relevance means that information is "capable of making a difference in the decisions made by users" (CPA Canada, 2019, QC2.6). The definition is further refined to state that information is capable of influencing decisions if it has predictive value, confirmatory value, or both. Predictive value means that the information can be used to assist in the process of making predictions about future events, such as potential investment returns, credit defaults, and other decisions that financial-statement users need to make. Note that although the information may assist in these decisions, the information is not in itself a prediction or forecast. Rather, the information is the raw material used by the decision maker to make the prediction. Confirmatory value means that the information provides some feedback about previous decisions that were made. Quite often, the same information may be useful for prediction and feedback purposes, but in different time periods. An income statement may help an investor decide to invest in a company this year, and next year's income statement, when released, will provide feedback as to whether the investment decision was correct. The framework also mentions the concept of materiality. A piece of information is considered material if its omission would affect a user's decision. Materiality is a concept used frequently by both internal accountants and auditors in determining the need to make adjustments for errors identified. Clearly, an item that is not deemed to be material is not relevant, as it would not affect a user's decision.
Faithful representation means that the financial information presented represents the true economic substance or state of the item being reported. This does not mean, however, that the representation must be 100 percent accurate, as perfection is rarely attainable. The CPA Handbook indicates that for information to faithfully represent an economic phenomenon, it must be complete, neutral, and free from error.
Information is complete if there is sufficient disclosure for the reader to understand the underlying phenomenon or event. This means that many financial disclosures will require additional explanations that go beyond a mere reporting of the quantitative values. Completeness is the motivation behind many of the note disclosures contained in financial statements. Because financial-statement users are trying to make predictions about future events, more detail is often needed than simply the balance sheet or income-statement amount. For example, if an investor wanted to understand a manufacturing company's requirements for future replacement of property, plant, and equipment assets, detailed information about the remaining useful lives of the assets and related depreciation periods and methods would be needed. Similarly, if a creditor wanted to assess the possible future effect on cash flows of a lease agreement, detailed information about the term of the lease, the required payments, and possible renewal options would be needed.
The neutrality concept suggests that the information is not biased and does not favour one particular outcome or prediction over another. This can often be difficult to assess, as many judgments are required in some accounting measures. There are many motivations for managers and preparers of financial statements to bias or influence the reporting of certain results. These motivations will be discussed later in this chapter. The professional accountant's role is to ensure that these biases are understood and controlled so that the reported financial results are not misleading to readers. Neutrality can also be supported by the use of prudent judgment. "Prudence is the exercise of caution when making judgments under conditions of uncertainty" (CPA Canada, 2019, QC2.16). Prudence has historically been described as a cautious attitude that does not allow for the overstatement of assets or income, or an understatement of liabilities or expenses. However, the definition in the Conceptual Framework equally suggests that assets or income should not be understated and that liabilities or expenses should not be overstated. The Framework makes this explicit statement to suggest that asymmetry in standards is not necessary. However, there are examples of specific standards in IFRS that do have unbalanced requirements (i.e. have a requirement for more persuasive evidence when recognizing an income compared to an expense). These types of unbalanced standards are considered acceptable if they result in more relevant and faithfully representative information. The application of prudence obviously takes a high degree of skill and professional judgment. Prudence is not considered a qualitative characteristic on its own, but is rather, sound advice to the practicing accountant.
As noted previously, information that is free from errors is not a guarantee of certainty or 100 percent accuracy. Rather, this criterion suggests that the economic phenomenon is accurately described and the process at arriving at the reported amount has properly applied. There is still the possibility that a reported amount could be incorrect. For example, at the end of the fiscal year, many companies will make an allowance for doubtful accounts to reflect the possibility that some accounts receivable will not be collected. At the balance sheet date, there is no way to be 100 percent certain that the reported allowance is correct. Only the passage of time will reveal the truth about this estimate. However, we can still say that the allowance is free from error if we can determine that a logical and consistent process has been applied to determine the amount and that this process is adequately described in the financial statements. This way, readers are able to make their own assessments of the risks involved in collecting these future cash flows.
It should be noted that the presence of both of the fundamental characteristics is required for information to be useful. An error-free representation of an irrelevant phenomenon is not much use to financial-statement readers. Similarly, if a relevant measure cannot be described with any degree of accuracy, then users will not find this information very useful for predicting future cash flows.
Enhancing Characteristics
The conceptual framework describes four additional qualitative characteristics that should enhance the usefulness of information that is already determined to be relevant and faithfully represented. These characteristics are comparability, verifiability, timeliness, and understandability.
Comparability is the quality that allows readers to compare either results from one entity with another entity or results from the same entity from one year with another year. This quality is important because readers such as investors are interested in making decisions whether to purchase one company's shares over another's or to simply divest a share already held. One key component of the comparability quality is consistency. Consistency refers to the use of the same method to account for the same items, either within the same entity from one period to the next or across different entities for the same accounting period. Consistency in application of accounting principles can lead to comparability, but comparability is a broader concept than consistency. Also, comparability must not be confused with uniformity. Items that are fundamentally different in nature should be accounted for differently.
The verifiability quality suggests that two or more independent and knowledgeable observers could come to the same conclusion about the reported amount of a particular financial-statement item. This does not mean that the observers have to be in complete agreement with each other. In the case of an estimated amount on the financial statements, such as an allowance for doubtful accounts, it is possible that two auditors may agree that the amount should fall within a certain range, but each may have different opinion of which end of the range is more probable. If they agree on the range, however, we can still say the amount is verifiable. Verification may be performed by either directly observing the item, such as examining a purchase invoice issued by a vendor, or indirectly verifying the inputs and calculations of a model to determine the output, such as reviewing the assumptions and recalculating the amount of an allowance for doubtful accounts by using data from an aged trial balance of accounts receivable.
Timeliness is one of the simplest but most important concepts in accounting. Generally, information needs to be current to be useful. Investors and other users need to know the economic condition of the business at the present moment, not at some previous period. However, past information can still be useful for tracking trends and may be especially useful for evaluating management stewardship.
Understandability is the one characteristic that the accounting profession has often been accused of disregarding. It is generally assumed that readers of financial statements should have a reasonable understanding of business issues and basic accounting terminology. However, many business transactions are inherently complex, and the accountant faces a challenge in crafting the disclosures in such a way that they completely and concisely describe the economic nature of the item while still being comprehensible. Financial disclosures should be reviewed by non-specialist, knowledgeable readers to ensure the accountant has achieved the quality of understandability.
As mentioned previously, accountants are often faced with trade-offs in preparing financial disclosures. This is especially true when considering the application of the various qualitative characteristics. Sometimes, the need for timeliness may result less-than-optimal verifiability, as verification of some items may require the passage of time. As a result, the accountant is forced to make estimations in order to ensure the information is available within a reasonable time. As well, all information has a cost, and companies will carefully consider the cost of producing the information compared with the benefits that can be obtained from the information, such as improving relevance or faithful representation. These challenges point to the conclusion that accounting is an imperfect measurement system that requires judgment in both the preparation and interpretation of the information.
