CONSTRAINTS ON FINANCIAL REPORTING

CONSTRAINTS ON FINANCIAL REPORTING

QC48. In addition to the qualitative characteristics of relevance, faithful representation, comparability, and understandability, decision-useful financial reporting is subject to two pervasive constraints: materiality and benefits that justify costs. The two constraints are linked because each concerns why some information is included in financial reports and other information, or the same type of information in different circumstances, is not.

Materiality

QC49. Information is material if its omission or misstatement could influence the resource allocation decisions that users make on the basis of an entity’s financial report. Materiality depends on the nature and amount of the item judged in the particular circumstances of its omission or misstatement. A financial report should include all information that is material in relation to a particular entity—information that is not material may, and probably should, be omitted. To clutter a financial report with immaterial information risks obscuring more important information, thus making the report less decision useful.

QC50. Materiality is considered in the context of the other qualitative characteristics, especially relevance and faithful representation. For example, whether information faithfully represents what it purports to represent should take into account the materiality of any potential misstatement. Thus, materiality is a pervasive constraint on the information to be included in an entity’s financial report rather than a qualitative characteristic of decision-useful financial reporting information. Materiality also differs from both the qualitative characteristics and the constraint of benefits that justify costs in that materiality is not a matter to be considered by standard setters.

QC51. It is not feasible to specify a uniform quantitative threshold at which a particular type of information becomes material. Materiality judgments are made in the context of the nature and the amount of an item, as well as the entity’s situation. For example:

a. Disclosure of the effects of an accounting change in circumstances that put an entity in danger of being in breach of covenant regarding its financial condition, or that help to avoid such a breach of covenant, may justify a lower materiality threshold than if the entity’s position were stronger.

b. A misclassification of an asset as equipment that should have been classified as plant may not be material because it does not affect classification on the statement of financial position; the line item “plant and equipment” is the same regardless of the misclassification. However, a misclassification of the same amount might be material if it changed the classification of an asset from plant or equipment to inventory.

c. An error of 10,000 in the amount of uncollectible receivables is more likely to be material if the total amount of receivables is 100,000 than if it is 1,000,000. Similarly, the materiality of such an error also may depend on the significance of receivables to an entity’s total assets and of uncollectible receivables to an entity’s reported financial performance.

d. Amounts too small to warrant disclosure or correction in normal circumstances may be considered material if they arise from abnormal or unusual transactions or events or if they involve related parties. Similarly, the amount of a misstatement that would be immaterial if it results from an unintentional error might be considered material if it results from an intentional misstatement.

QC52. In addition, the amount of deviation that is considered immaterial may increase as the attainable degree of precision decreases. For example, the amount of accounts payable usually can be determined from supplier invoices more accurately than can liabilities arising from litigation that must be estimated, and a deviation considered material for the first item may be immaterial for the second.

Benefits and Costs

QC53. The benefits of financial reporting information should justify the costs of providing and using it. The benefits of financial reporting information include better investment, credit, and similar resource allocation decisions, which in turn result in more efficient functioning of the capital markets and lower costs of capital for the economy as a whole. However, financial reporting and financial reporting standards impose direct and indirect costs on both preparers and users of financial reports, as well as on others such as auditors or regulators. Thus, standard setters seek information from preparers, users, and other constituents about what they expect the nature and quantity of the benefits and costs of proposed standards to be and consider in their deliberations the information they obtain.

QC54. The economy and society as a whole are the ultimate beneficiaries of financial reporting that exhibits the qualitative characteristics to the maximum extent feasible. The benefits of financial reporting information include more efficient functioning of the capital markets, which may result in better availability and pricing for consumers, and in better opportunities and compensation for employees and other suppliers of services or goods. Preparers of decision-useful financial reporting information enjoy other benefits also, including improved access to capital markets, favorable impact on public relations, and perhaps lower costs of capital. The benefits may also include better management decisions because financial information used internally is often based at least partly on information prepared for external reporting purposes.

QC55. The direct costs of providing information include costs of collecting and processing the information, costs of having others verify it, and costs of disseminating it. Direct costs necessitated by changes in financial reporting include revising collection and processing systems and educating preparers, managers, and investors and creditors. Indirect costs may arise from litigation or from revealing secrets to trade competitors or labor unions (with a consequent effect on wage demands).

QC56. The costs that users incur directly are mainly the costs of analysis and interpretation, including revision of analytical tools necessitated by changes in financial reporting requirements. Users’ costs may also include costs of separating decision-useful information from other information that is less useful or redundant. However, not requiring decision-useful information also imposes costs, including the costs that users incur to obtain or attempt to estimate needed information using incomplete data in the financial report or data available elsewhere.

QC57. Preparers incur the direct (and most of the indirect) costs of providing financial information, but investors and, to a lesser extent, other providers of capital ultimately bear those costs in the form of reduced returns to them. Preparers may also be able to pass some of those costs along to customers. Initially at least, the benefits of new financial reporting information may be enjoyed by parties other than those who bear most of the costs. Ultimately, however, both the costs and the benefits of financial information are diffused widely throughout the economy.

QC58. In assessing whether the benefits of a proposed standard are likely to justify the costs it imposes, standard setters generally consider the practicability of implementing it and whether some degree of precision might be sacrificed for greater simplicity and lower cost, in addition to other factors. Standard setters’ assessment of whether the benefits of providing information justify the related costs usually will be more qualitative than quantitative. Even the qualitative information that standard setters can obtain about benefits, in particular, and costs often will be incomplete. Nevertheless, standard setters should do what they can to assure that benefits and costs are appropriately balanced.

QC59. Constituents sometimes express concern that the availability of newly required financial reporting information will lead to economic consequences that are adverse to them or to others. Whether the perceived economic consequences of improved financial reporting information may be detrimental (or beneficial) to particular entities or groups of entities are not costs (or benefits) that standard setters can appropriately consider. To do so would result in information that fails the test of neutrality (paragraphs QC27–QC31). Such consequences, if they occur, result from the availability of financial reporting information that is more useful for making resource allocation decisions than the information previously available.